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The answer to "What's going to give the Fear Index a boost ?" was staring us in the face all along .... The threat of Thermonuclear War,...

August 11, 2017

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The Harbingers of Doom just love this yield curve ......

April 3, 2018

 

ref :- "Narrow times  /  Flatter US yield curve signals economic concerns" , The Financial Times, Companies and Markets

We hear an awful lot about the flattening yield curve, how the premium of longer-term rates over the shorter-term equivalents is diminishing. Not surprising really, as it's a widely-held belief that flat yield curves signal a danger of economic slowdown and that if they actually become inverted (short-term rates higher than long-term rates) , then we're headed for recession.

The most popular measure of the US yield curve is the spread between yields on 10yr and 2yr Treasuries (10yr minus 2yr). Now trading below 50 basis points (last at 48), the spread is at it's narrowest since August 2007 and is down from 114bp a year ago and from 78bp as recently as Feb 8th. Unsurprisingly, some cautionary bells are ringing. Mind you, they were also ringing a bit at the end of last year when the spread got into 50bp before the fiscal stimulus package widely perceived as inflationary (which would be particularly bad for long bonds and push yields higher) prompted that widening out to 78bp. It's still perceived as inflationary, it's just that there's no evidence of it yet and maybe that disappointment has led to the increased noise surrounding this bout of spread tightening. 

Commentators can say what they like about increased levels of volatility only being a "healthy" return to normality but equity markets seem to have had their confidence dented ever since February's bout of volatility, a condition not helped by looming trade conflict and the turmoil in the all-important technology sector. At the very least stocks are looking more vulnerable to "bad" news than they were in 2017, when they seemed impervious to it and saw any dip as a buying opportunity. The potentially bearish signal being sent by the bond markets  --  the flattening yield curve  --  is perhaps finding more of an audience now than it did earlier in the stock market's seemingly inexorable rise.

So what's driving the curve flattening ? Well, amongst other things .....
hip between growth, employment and inflation  --  and therefore rates and yields  --  to calm any nerves.
At the short end, tightening of monetary policy by the Federal Reserve pushes up overnight borrowing costs with knock-on effects to other shorter-maturity instruments. With two more rate hikes due this year (and three next), the potential for further spread tightening is obvious unless longer-term yields also resume the upward path that stalled in mid-February.  At the same time, the US Treasury has implemented a policy of funding the widening government deficit by issuing a preponderance of government debt with shorter maturities, thus pushing up shorter-term yields in comparison to the long end. The "risk-off" environment that is a result of increased volatility and a shake-up in stock markets has also caused investors to exit equities in favour of the safety of long-dated Treasury markets (prices higher / yields lower).

As ever when talking long bond markets, and as we alluded to earlier, the biggest driver keeping a cap on yields and therefore causing the 10yr over 2yr spread to narrow is inflation, or rather the lack of it. (Remember, inflation is very bad for long bonds as it eats into future fixed returns). When the 10yr yield hit a high of 2.96% in February, many respected judges felt that a  break of 3.00% was imminent, which would signal a quick move to higher levels. They were wrong, or at least they have been so far .... which is not to say it won't happen but just like the Fed itself they'll be hoping for some manifestation that super-strong employment data is finally spilling over into inflation numbers. 

As to whether this curve flattening portends any serious economic slowdown or even a recession .... well, we'd first of all urge some perspective and point out that we're not yet at that point. Actually, periods when the yield curve has been shallow (but not inverted) have historically been some of the most productive for economic growth. And whilst it's true that inversions of the yield curve (with short-term rates overtaking long-term yields) have preceded the last five recessions, it's by no means the case that all inversions automatically do so  --  they don't.

But given the fact that this growth period in the US, whilst not always hugely robust, has gone on for so long there's bound to be a lot of anxiety if this well-watched indicator continues to narrow. And if it does, don't expect any rumination about possible changes in the dynamics behind the relationship between growth, employment and inflation  --  and therefore rates and yields  --  to calm any nerves.

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