What’s the US yield curve signaling?

A flattening yield curve moving toward an inverted curve traditionally has been seen as a sign of a pending recession. Investment Strategist Terry Simpson explains why this may not be the case today.

In recent weeks, the difference in yields between 10-year and 2-year U.S. Treasuries has hit post financial crisis lows, as evident in the chart below. Declining long-term yields have primarily driven this drop, as expectations for a near-term Federal Reserve (Fed) rate increase have plummeted amid poor May U.S. jobs growth and Brexit worries.

chart-bond-flatter

This difference in yields, otherwise known as the “2s10s” spread or curve, historically has been viewed as a barometer of the economic outlook. A flattening curve, like the one we’re witnessing today, that moves toward an inverted curve (i.e., where 2-year yields are greater than 10-year yields) traditionally has been seen as a sign of a pending U.S. recession.

The flattening yield curve today, however, shouldn’t necessarily be interpreted as a sign that a U.S. recession is ahead. Here’s why.

Different factors are behind the shape of today’s yield curve

Worries about the economy are traditionally what drive curves from flattening to inverted. When investors become worried, they tend to shift their money out of cash or short-term Treasuries and buy longer-term Treasuries, pushing 10-year yields down and short-term yields up. Economic worries are certainly still playing a role in flattening the curve, this time around. Case in point: The recent drop in Treasury bond yields after the U.K.’s surprise vote to exit the European Union. However, the global economic recovery has languished for years, meaning other factors are also biasing the curve flatter.

One factor is the scarcity of yield across the globe

The 10-year yield recently went below 1.5%, according to Bloomberg data. In absolute terms this is near post-crisis lows. Relative to German 10-year debt and Japanese 10-year debt, at negative yields, the 1.5% yield makes U.S. debt attractive even accounting for the cost to hedge currency risk. Additionally, the European Central Bank (ECB) began a new corporate bond purchase program earlier this month, depressing European government bond yields even further and driving up demand for Treasuries.

Another factor is the Federal Reserve’s (Fed) influence

The Fed’s three rounds of quantitative easing (QE) were designed to add further monetary stimulus, after interest rates had already been cut to zero percent as part of the Fed’s Zero Interest Rate Policy (ZIRP). The aim of QE, in economic terms, was to reduce the term premium, the compensation that a bond investor earns for investing in a longer maturity bond as opposed to a series of shorter maturity bonds. Even though the Fed stopped its last round of QE in December 2013, the effect on the term premium is still present. The New York Fed estimates that the current term premium sits at -0.41%. In other words, investors aren’t rewarded for owning a US Treasury 10-year bond debt in lieu of a combination of shorter maturity bonds.

But regardless of whether today’s yield curve is a harbinger of a worsening economy, you may still be wondering where the curve is heading. In this cycle, watching both 2-year and 10-year Treasuries will be key for determining this. Our analysis shows both the short- and long-end of the curve have explained the movement in the “2s10s” spread in a post-Taper Tantrum world.

Given the the Fed’s recent rate projections and the potential impact of Brexit, the implication is that the long run destination for short-term rates is low.

My best guess for the 2s10s spread going forward: there remains some residual flattening in this cycle due to the factors above, but there’s a low probability of an inverted curve.

 

Terry Simpson, CFA, is a multi-asset strategist for the BlackRock Investment Institute. He is a regular contributor to The Blog.

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