The rise in U.S. rates and the flattening of the yield curve have led to concerns about possible recession risks. In particular, worries about a curve inversion–a frequent leading indicator of recession–flared up due to the increase in short-term rates. We think the ascent of the short-end rates largely reflects greater confidence in the growth and inflation outlooks–and has largely run its course, as markets have priced in further interest rate increases.
The long-end U.S. rates have also been rising. The benchmark 10-year U.S. Treasury yield breached the psychologically important 3% level before last week’s sharp reversal. See the green line in the chart. Meanwhile, the consensus GDP growth forecast has risen substantially in the past year (the blue line), though increased uncertainty around growth and inflation, along with concerns about elevated Treasury supply, have been more important drivers in the past few months. Our U.S. BlackRock Growth GPS has come off a bit but still sees upside to the consensus forecast. The rise of the 10-year yield may be limited, however, as we see slower long-run growth anchoring rates all along the yield curve at historically low levels. For long-end yields in particular, elevated global savings suggest investors are still willing to pay a premium for the perceived safety of U.S. government bonds. This helps hold yields down.
A flatter curve and rising rates: a deep dive
The increase in short-term U.S. rates has contributed to the flattening of the yield curve–and stirred worries of a curve inversion. Yet there are reasons why today’s curve flattening may be less informative than in previous cycles. First, today’s flatter curve was the intent of quantitative easing programs globally. Central banks extended accommodation by lowering long-end rates and depressing the term premium. Second, financial markets are becoming ever more integrated: Low yields on longer-maturity bonds in Europe and Japan are weighing down their U.S. counterparts despite higher hedging costs. Third, higher short-maturity Treasury issuance has contributed to the flatter curve recently. A curve inversion may be unlikely in any case. The steady U.S. inflation outlook, evident in our BlackRock Inflation GPS, suggests the Fed is unlikely to raise rates much more than already telegraphed.
The behavior of equity markets provides further reason to believe the flattening of the yield curve does not indicate an imminent downturn. Developed market equities have generally shown resilience in the last three months despite rising rates. Rising rates have contributed to a decline in equity valuations this year, but this has been offset by stronger earnings, particularly in the U.S. Moreover, cyclicals have been outperforming defensive stocks as the yield curve has flattened–suggesting confidence in the expansion is still strong.
Rising U.S. rates matter–both the pace of the move and the ultimate level. The rate of ascent will likely slow, we believe, as the adjustment to higher growth and inflation expectations appears mostly in the rear-view mirror for short-end rates, while structural factors are capping the long-run level of yields. We see better risk-reward at the short end of the curve and do not expect the curve to invert.