The flattening US yield curve has been, to some commentators, an early omen of an inversion. In turn, an inverted yield curve often portends a recession with remarkable reliability. At the very least, it would suggest that investors lack confidence in the prospects of the US economy, which is surprising given the current economic data. However, such fears are unjustified. Nevertheless, it is one of the most important and widely-discussed topics in financial markets.
Risks and Rewards
To begin, the Treasury yield curve measures the spread between short- and long-term debt issued by the US government. It is the ‘term premium’ that investors demand to lock away their money for an extended period. Lending money over a longer period is inherently riskier. Therefore, investors require more reward for accepting such default risk.
For context, the US economy is currently showing remarkable dynamism and is experiencing its second-longest growth spell on record. The unemployment rate has continued to trend lower since August, dropping from 4.4% to 4.1% in October. This is paired with buoyant consumer confidence. The Conference Board Consumer Confidence Index hit 129.5 in November, its highest reading since November 2000. Clearly, the US economy is energised.
Meanwhile, inflation remains stubbornly low, with core consumer prices, which strips out food and energy prices, below the Federal Reserve’s 2% target. Crucially, the Fed has developed a reputation as an inflation fighter over the last few years and has gained credibility in the bond markets through executing its planned rate hikes. Such credible monetary policy is probably suppressing the yield on longer-dated treasuries which are more sensitive to inflation expectations and economic growth than short-dated bonds. Conversely, shorter maturity bonds tend to be more sensitive to short-term interest rate expectations.
Short and Long Term
The two-year US Treasury yield is over 1.75%, driven by 25bp rate hike expectations at the next FOMC meeting on December 13th and beyond into 2018. Meanwhile, the key driver behind the flattening has been a reduction in the term premium on longer-dated bonds. This is bringing the yields of short- and long-term bonds closer to each other. Hence the phrase ‘flattening’ of the yield curve.
It could be argued that a precise set of circumstances means that the bond market may have entered a ‘new normal’ and that the predictive power of the yield curve is diminished. For example, the yield on longer-term maturities is probably being influenced by the aforementioned weak inflation expectations.
Supply and Demand
There are also several other forces that might be at work here. Supply and demand forces may be behind the fall in longer-term yields. Passive mutual funds such as Vanguard and BlackRock have increased their demand for longer-dated Treasuries, creating extra demand and thereby lowering yields.
Meanwhile, supply forces from the Treasury are also shaping the market, with the Treasury recently announcing that it wants to focus on issuing shorter-dated maturities, creating a shortage of supply. Finally, the trillions of dollars’ worth of central bank stimulus built up over the last few years continue to put enormous pressure on bond yields. The European Central Bank, which is tapering its asset purchases by less than markets expected, has driven a wedge between the 10-year US and German yield with ultra-loose monetary policy, thus creating an incentive to invest in American debt. It has also focused its asset purchases on longer-dated debt.
Regardless of the exact reason behind the flattening of the yield curve, it does not appear probable that a recession in the US is imminent. It is likely that the yield curve will continue to flatten in 2018 in the absence of a pick-up in inflation.
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