Market Views: Fixed Income
Yield curve flattening: overdone or more to come?
Investors often fear a flattening of the US yield curve as it tends to suggest a lower growth environment ahead. But we think quantitative tightening will likely have an unprecedented impact on the US bond market, just as QE did.
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A flatter US yield curve is often associated with a future slowdown in economic growth. Indeed, there are now frequent comments in the financial press about this historic correlation and rising chances of an upcoming recession.
We do not see the recent yield curve flattening as a harbinger of slower US growth – here’s why:
- Interest rates are still very low whether measured absolutely or in real terms, liquidity remains ample and the overall robust health of the US banking system suggests credit will remain widely available
- Moreover, the pace of monetary tightening remains glacial compared to other periods when the Federal Reserve (Fed) raised interest rates
- That said, as will be illustrated below, there are additional factors which suggest the pace of yield curve flattening will slow and even steepen somewhat in coming quarters
Yield curve trends
Investors often look at the slope of the yield curve, or the spread between two-year Treasury yields and 10-year Treasury yields, as a signal of expectations for growth and inflation. A flatter curve often implies declining growth expectations, while a steeper curve often implies expectations of increasing growth and inflation.
This year the curve has undergone considerable flattening, which has accelerated over recent weeks. This is not unexpected as flattening yield curves often coincide with central bank tightening cycles. Typically, the Fed raises rates to slow the rate of growth and inflation, and to temper any “excessive exuberance” that may have resulted. Historically, aggressive and over zealous tightening has led to the end of the economic cycle.
While the Fed is raising short-term rates, long-term rates tend to be better anchored and reflect longer term fundamentals.
In particular, two factors have a larger influence on long-term yields: (1) expectation of short-term rates over a much longer period and (2) extra compensation demanded for owning a longer maturity bond. This second component is known as term premium and reflects the inherent uncertainty related to unexpected changes in supply, demand, and inflation.
As of today’s writing, two-year yields are at nine-year highs of 1.70%, while current 10-year yields of 2.35% are below where they started 2017. The resulting yield curve flattening is clearly seen below.
Recent yield curve flattening has been driven by a combination of the Fed raising interest rates in 2017, along with an unusual increase in demand for longer maturities from non-US investors whose home-market yields remain well below those available in the US.
During the past six Fed tightening cycles (going back to 1984), the curve flattened in all but one of them. The outlier cycle was in 1986-87, when there was concern that the Fed would tolerate higher inflation caused by a weaker dollar and the federal budget deficit was increasing as tax reform was rolled out. Although historical precedent tells us that the yield curve should flatten further as the Fed continues to raise rates there are reasons why this time could be different, and we could see a curve steepening from here.
This time is different
This economic cycle has been characterized by extraordinary monetary policy in the form of quantitative easing (QE), one of the goals of which was to decrease long-term rates in order to stimulate credit expansion. To accomplish this goal, the Fed bought significant amounts of long-dated Treasury bonds – at one point, holding nearly 50% of all of the outstanding 30-year Treasury supply – in hopes of reducing term premium.
Now that the Fed has begun to reduce its balance sheet, or unwind QE, we could see a reversal of this policy.
Remember, not only was the scale of QE unprecedented, but there is no comparison in modern financial history to how markets will react to its reversal. Term premium tends to be globally correlated, so any policy changes by the European Central Bank, Bank of Japan, or People’s Bank of China could also cause long-end yields to stop falling.
We expect that the supply of fixed income assets globally will rise materially in the coming quarters as central banks step back from their easing policies; this will likely lead to a normalization (rise) of term premium globally.
Long-term interest rates could also increase because of changes in fiscal policy, specifically deficit-fueled programs that increase Treasury supply. Although there are plans for expansionary fiscal policy coming out of Washington, the market expects this to be broadly funded with short-maturity Treasuries rather than long-maturity bonds. If the Treasury unexpectedly decides to increase long-dated issuance in order to fund some of this expansion, the Treasury curve could steepen. Expanding budget deficits in the late 1980s may have contributed to the unusual steepening during that tightening cycle.
Finally, changes in the Fed’s mandate could also influence the yield curve. Currently, the Fed has the dual goal of maximizing employment while keeping inflation stable. It has indicated a 2% price inflation target; however, it has also struggled to achieve that goal. Consequently, from time to time, there has been talk about raising the inflation target, or letting inflation persistently run above target, in order to influence pricing behaviour.
Recently, Chicago Fed President Charles Evans suggested raising the target to 2.5% in order to prevent low inflation expectations from becoming entrenched. This type of policy shift would likely cause long-end yields to rise as longer-term inflation expectations increase term premium.
Yield curve flattening in 2017 has been driven by a combination of tighter monetary policy by the Fed and an increase in demand for long maturities as inflation has remained low. However, these conditions do not suggest a period of weaker growth ahead. To the contrary; interest rates remain low by any measure, and US fiscal policy is likely to become more stimulative.
Given recent market positioning data, we believe it is clear that investors expect more flattening to come. Although history would dictate that this view has merit, it is possible that there may be some unexpected steepening pressure to come. We would be cautious about reading too much into this year’s flatter yield curve.