The US yield curve has been flattening all year, that’s to say, the gap between long-term US bond yields and shorter-term interest rates is getting smaller.
The absence of inflation has led to a flatter yield curve in 2017
As Exhibit 1 below shows, the differential between two and 10-year US Treasury yields has been falling since the autumn of 2016 when Donald Trump’s surprise election as US presideent provoked a back-up in bond yields based on the market perception that the policies of the new administration would unleash inflationary pressures. So far, no such luck – US inflation has remained surprisingly low throughout 2017 and repeatedly fallen short of market expectations.
Indeed, the yield curve has flattened further recently and in the week ending 24/11/2017, the differential approached the level of 50bp for the first time since November 2007, while the spread between two and 30-year Treasuries fell to almost 100bp (see Exhibits 1 and 2 below).
Exhibit 1: A flatter yield curve in 2017 – the differential between interest rates of US 2-year and 10-year Treasuries has fallen
Exhibit 2: A reach for ‘quality yield’ ? This year, the US yield curve has also flattened between two-year and 30-year maturities
The yield curve – a predictor of future economic growth (?)
The flattening is surprising because at a time when the Federal Reserve is raising short-term interest rates (admittedly at a rather pedestrian pace – once in 2015, once in 2016 and twice so far this year with another hike of 25bp expected in December), the rates on longer-term Treasuries are generally expected to rise.
The slope of the yield curve is regarded as a ‘canary in the coalmine’ for its ability to forecast future economic growth. Generally, a steep yield curve is reckoned to indicate strong growth and conversely, a flat curve points to weak growth.
According to the Federal Reserve Bank of Cleveland, an inverted yield curve (short rates above long rates) indicates a recession in about a year. Yield curve inversions have preceded each of the last seven recessions (as defined by the US National Bureau of Economic Research).
For example, the US yield curve inverted in August 2006, a little over a year before the start, in December 2007, of the most recent recession. Though it should be noted that on two occasions, in late 1966 and late 1998, yield curve inversions were not followed by recessions within 12 months.
Exhibit 3: The inversion of the US yield curve has often been followed, within 12 months, by a recession
Source: Bloomberg, BNP Paribas Asset Management, as of 29/11/2017. Graph shows changes in the differential in basis points between interest rates of 10-year and 2-year US Treasuries between 06/12/1980 and 29/11/2017
So what is happening this time?
Expectations for inflation trends over the next few quarters should not influence 10-year bond yields, where the long-run perspective is what matters. As a recent post on the Federal Reserve Bank of San Francisco’s (FRBSF) blog points out, long-term inflation expectations in surveys have not moved in 2017.
What has fallen, however, is inflation compensation, the difference between nominal Treasury yields and, real, inflation-indexed yields based on the prices of Treasury Inflation-Protected Securities (TIPS). The decline in this measure along with a fall in the inflation risk premium (the premium compensating investors for the uncertainty over future bond returns due to changes in inflation) suggests to the FRBSF that investors are prepared to pay a higher price for nominal bonds because they increasingly view them as a hedge against low inflation.
If this view is right, we are not out of the low-flation, disinflationary environment of recent years. If you believe that the business cycle still exists (and we do), a recession will come along in due course, but we see no sign that it is imminent.
On the contrary, economic growth is picking up. We are, however, very much of the view that inflation will not be rearing its head in 2018. It’s a topic we will cover in more detail in our forthcoming Investment Outlook. So watch this space.
Written on 29/11/2017