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Flattening yield curve is nothing to worry about

Flattening yield curve is nothing to worry about

The shape of the US Treasury yield curve – the difference between the yield on short- and long-dated government bonds – may provide important signals about the health of the economy.

The shape of the US Treasury yield curve – the difference between the yield on short- and long-dated government bonds – may provide important signals about the health of the economy.

Typically, long-dated bonds yield a higher return than short-dated bonds, and this results in an upward-sloping curve. But this yield gap has narrowed dramatically over the past year, as the curve has ‘flattened’. The spread between three-month bonds and 10-year bonds has almost halved in the past 12 months, from nearly 200 basis points (bps) to around 100 bps. Extrapolating this trend, could the yield curve soon invert? Could long dated bonds yield less than short dated ones? And why might this matter?

The short answer is that inverted yield curves can give advanced warning of impending recession. As the Federal Reserve Bank of New York notes: “since 1960, a yield curve inversion… has preceded every recession on record.” It also points out that “there were no false positives during this period” – in other words, no episodes where an inversion was not subsequently followed by a recession.

So is the recent curve flattening cause for alarm?

What drives the shape of the yield curve?

Two factors can drive changes in the shape of the yield curve. First, there is the expected future path of the interest rate set by the central banks. Second, there is the ‘term premium’. Essentially, this represents the compensation investors demand to hold a long-dated bond instead of a series of short-dated bonds.

Past inversions of the yield curve have typically been driven by changes in expectations about central bank behaviour. In other words, investors have taken the view that the central bank’s policy rate will be much lower in the future because we are about to enter into a rate-cutting cycle. Since this is presumably because growth and inflation are expected to fall sharply, it is easy to understand why this type of inversion generally foreshadows a recession. In such circumstances, the shape of the curve is not really showing investors anything they don’t already know. After all, it is their expectations of a worse economic future that has driven the flattening and inversion.

However, this time it may well be different.

The recent flattening of the curve has been caused at least in part by a fall in term premium. It is not entirely clear why investors have begun to demand less compensation for holding long-dated bonds. However, it might be some combination of:

  • the perception that inflation risks have fallen;
  • continuing quantitative easing from the European Central Bank and Bank of Japan; and
  • very high levels of desired savings in the emerging world, which tends to increase demand for US government bonds.
  • A flattening driven by falling term premium sends a very different signal about the state of the economy.

    Regardless of the precise cause, a flattening driven by falling term premium sends a very different signal about the state of the economy.

    How might the Fed respond?

    Rather than acting as a harbinger of recession, a flattening curve driven by falling term premium might actually cause the Federal Reserve (Fed) to worry about excessively strong growth. By hiking raising rates, the Fed is aiming to tighten financial conditions in a bid to slow growth and stop the economy overheating. Higher long-term yields are a vital component of tighter financial conditions. So a flatter curve might directly contradict the Fed’s interest, prompting policy makers to raise policy rates even more rapidly.

    Even if the curve were to invert soon, driven by the expectation of future rate cuts, this would not necessarily signal a recession or compel the Fed to take future rate rises off the table.

    First, there are times when it is perfectly appropriate for the policy rate today to be above its long-term equilibrium level. When the economy is at full employment and spare capacity has been used up, above-trend growth causes inflationary pressures to mount. In such a circumstance, central banks should be in the business of tightening financial conditions, and this could well push the policy rate above its long-run level. The US economy could find itself in this position soon; the recently passed tax cuts provide a further growth boost to an already strong economy. The Fed may respond by pushing interest rates above their equilibrium level. In this situation, an inverted curve would be no more than a signal that the Fed is doing its job - and certainly not a reason to think it will pull back from its hiking cycle.

    Second, interaction between Fed policy and the yield curve makes forecasting extremely complex. If the Fed were to observe an inverted yield curve and decide that this is a signal of heightened recession risk, then it might decide to support growth by stopping its hiking cycle. The Fed’s policy change may be enough to avert the very recession that the curve was originally signalling. In which case, the observable relationship between an inverted curve and a recession would break down, because the curve provided a self-unfulfilling prophecy about the future of the economy.

    So both investors and the Fed would be wise to avoid putting too much weight on the apparent predictive power of the yield curve.

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