Is it time to hit the panic button yet?

One of the biggest points of contention in financial circles these days is the interpretation of the flattening yield curve. With rising short-term interest rates and a low term premium, the spread between yields on the short and long end of the spectrum is narrowing. From members of the Federal Open Markets Committee to analysts, financial pundits are split on the implications of the falling long-term US Treasury bond yields. On June 28th, James Bullard, President of the Federal Reserve Bank of St. Louis categorically stated that the inversion of the yield curve was a key near-term risk for the Fed and expressed caution about the pace of rate hikes1. On the other hand, some participants in the most recent meeting of the FMOC questioned the reliability of the slope of the yield curve in indicating future economic activity given the unique circumstances that are driving this trend.


Amidst the overwhelming information available on term structure trends, its predictive powers and determinants, the distinction between fact and opinion are often blurred. A clear understanding of this distinction is imperative as the yield curve influences exchange rates, the cost of borrowing, returns on investment and economic activity in general.


The path of the spread between 2 and 10-year Treasuries


Source: Bloomberg


The uncontested facts 


10-year US Treasury bond yield is at an 11-year low of 2.83%2


On July 5th, 2018, the spread between the 2 and 10-year treasures was 29 basis points , the narrowest since pre-recession levels in 20072


Every U.S recession in the past 60 years was preceded by an inverted yield curve (long-term yields are lower than short-term yields) and every negative term spread was always followed by an economic slowdown3


As a result of the aforementioned facts, market participants are closely watching the yield curve as a signal of the domestic growth trajectory. Currently, there are contrasting opinions on the medium-term trends in the current spread between short and long-term yields and the economic impact .


Where next?


Jerome Powell, Chairman of the Federal Reserve acknowledged that in a period of rising short-term rates and sustained demand for risk-free Treasury bonds amidst global trade uncertainty, a flattening yield curve is imminent. Additionally, funding the US budget deficit using treasure bills have put an upward pressure on the near-term yield.


At the start of 2018, another segment of the market believed there could be an upward pressure on the back-end of the yield curve  primarily driven by two factors:



However, the actions and discussions by the Fed so far haven’t added much impetus to the expectation for rising long-term rates. The yield curve can be expected to continue to flatten  .


What now?


Many in financial circles  acknowledge that the next stage in what is currently one of the longest economic expansions in US history is a slowdown. However, the contention of the market is the timing of this next phase. One school of thought advocates that purely based on statistical significance and predictive power, there is a high probability of a recession soon to follow3 if the spread between the 2 and 10-year Treasuries moves close to 0. The opinion is that history will repeat itself and it warrants a more cautious approach to monetary policy tightening.


Opponents of this theory argue that the circumstances under which the current yield curve is flattening are not indicative of an imminent threat to domestic growth. An analysis reveals that the probability of the yield curve inversion in the next three months is ~21%; this probability decreases over the next year.





Hard macroeconomic indicators  tracked by the Fed such as the PMI (revised higher from 54.6 to 55.4 in June 2018) and PCE (2.3% in June 2018; above the 2% target), do not indicate a near-term concern. Another argument is that the low term premium on long-dated securities is not just an indication of declining expectations but the search for higher yield by foreign investors from countries with loose monetary policies. Therefore, one should be cautious about establishing a strong causal relationship from historical data.


Overall, can expect the Fed to continue tightening monetary policy which will, in turn, lead to the narrowing of spreads between long and short-term treasuries. As a result, the US Dollar could continue its upward trajectory in the short term. Therefore, don’t hit the panic button yet but continue to stay close to new developments.



Author: Chris Jerome





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