The flattening of the US yield curve has raised concerns that a recession could be on the cards and has prompted some economists speculate whether it will soon invert.
The yield curve – which plots the interest rates offered by bonds with the same credit quality but different maturity dates – has continued to flatten in recent months as investors have come to expect lower rates for longer.
“Markets expect the Federal Reserve to deliver at least two additional interest rate hikes in 2018,” said Quentin Fitzsimmons, portfolio manager of the T. Rowe Price Dynamic Global Bond fund.
“Beyond this, US interest rate futures indicate markets are priced for one interest rate rise in 2019 and none the following year.
“Reflecting these expectations, the Treasury market has flattened considerably, with the short-end selling off aggressively and the long-end anchored by expectations the Fed’s terminal rate will be lower in this cycle.”
Some economists have come to speculate that the current flattening of the curve could see it invert at some point soon.
According to the latest Bank of America Merrill Lynch Global Fund Manager Survey, more than 50 per cent of asset allocators believe that the yield curve could invert during 2019.
When do you think the yield curve will invert?
Source: Bank of America Merrill Lynch Global Fund Manager Survey
As a barometer of the health of the economy this has alarmed investors, particularly as there has been some historical evidence to suggest that an inverted yield curve has followed by a recession within 12 to 18 months.
In normal circumstances the yield curve indicates that the yields offered by short-dated bonds are lower than those offered by longer-dated government bonds.
Investors putting their capital at risk for longer would demand higher yields than they would over shorter time periods, known as ‘term premium’.
Conversely, if investors believe that an economy is going to slow, expectations that interest rates will decline to help stimulate growth, pushing up demand for long-dated bonds and driving yields down.
According to AXA Investment Managers, the spread between three-month and 10-year US Treasuries has inverted before each of the past seven recessions, including 2008.
However, since the last recession central banks around the world have undertaken quantitative easing (QE) schemes to help shore up embattled banks and encourage lending following the financial crisis.
With huge sums flooding the market and interest rates lowered to help stimulate economies, the traditional relationship between assets may have broken down, suggested AXA.
As such, yields across the curve have fallen until lately when the synchronised global growth seen last year seemed to signal that the global economy was on surer footing and yields rose.
“Nevertheless, while the economy has improved markedly, inflation remains stubbornly low,” noted AXA analysts.
“So even as the US Federal Reserve is increasing short-term interest rates, the lack of inflation has meant that investors have continued to remain buyers of long term debt, which has helped support prices and, thus, a lid on yields.
“This has been exacerbated by the ongoing demand for long-term debt from central banks and insurance companies charged with ensuring that their assets match their liabilities.”
Source: M&G
Tristan Hanson, lead manager of the £93.5m M&G Global Target Return fund, said the obsession with the yield curve was “curious” adding that “there appears nothing especially unusual going on”.
He said: “In an environment where inflation expectations are relatively stable, as the Fed funds rate rises it is entirely normal for the curve to flatten.
“There is evidence that an inverted curve predicts recession, which the Fed is right to worry about. But that is not the present signal from the bond market. The yield curve is flatter, but upward sloping.”
“Most Fed watchers, for now at least, don’t think the US economy requires a Fed funds rate much above 3.5 per cent in the foreseeable future,” Hanson added.
“This is why long-dated bond yields currently sit below this level. For as long as this belief holds and the Fed lifts rates upwards towards this level, the curve will flatten. Of course, beliefs can change.”
The M&G manager said recent comments by the Fed suggest that there is no great upward inflation threat and no need to rush the pace of interest rate increases.
“Ultimately market expectations will wax and wane,” he added. “It remains to be seen whether this is enough to stop further flattening, but it highlights the extent to which the Fed should be wary of overcomplicating what these curve slopes imply.”
Additionally, higher levels of indebtedness since the financial crisis has also put pressure on the Fed to maintain low rates, according to AXA.
Non-financial commercial paper outstanding
Source: St Louis Federal Reserve
While debt remains manageable in the current environment, higher rates could see borrowing costs increase for all.
Adrien Pichoud, chief economist at SYZ Asset Management, said along with 10-year US Treasury yields reaching the symbolic 3 per cent level, the flattening of the yield curve was more representative of the post-crisis economic conditions and in itself wasn’t necessarily a pre-cursor or a recession.
“This pattern is quite usual when an economy reaches the latter part of the expansion cycle,” he said. “However, it shouldn’t be prematurely interpreted as a recession signal, as a very flat yield curve can persist for several quarters: the US yield curve was already flat at the end of 2005, two years ahead of the 2007-8 recession.”