Mind the Curve

There is concern about the US treasury yield curve. It has flattened, meaning the difference between long term rates and short term rates has narrowed.  Yields on the two maturities are a mere 35 hundredths of a point apart. Some believe that the curve will invert. Inversion has often been a harbinger of recessions. It is possible that inversion, if and when it comes, will foreshadow the next downturn. Before you start hyperventilating about that possibility, be aware that there are other reasons the yield curve flattens, uncertainty among them.

2s10sJune2018
2s10s has narrowed, but will it invert? The late 90s show another potential outcome.

Trade policy uncertainty wreaking havoc on a previously complacent stock market, modest inflation expectations and little likelihood of a permanent acceleration in growth from a 2% rate may all help explain why the ten year has failed to remain above 3% and continue to rise. Since two year yields follow Fed policy, they have risen as the Fed has tightened and voila, the yield curve has narrowed.

So, while it is worth noting this, it is not (yet) time to panic. Recession signaling is not the only reason the yield curve compresses. The relationship between short and long treasury yields can remain narrow for years, as it did in the second half of the nineties.

YC3mChange062118

Ten year yields have barely budged in the last three months

Here are some potential reasons why long rates have not risen or have fallen a bit over the last three months, helping flatten the curve:

  • Long treasuries are an asset investors flee to when the world seems indecipherable. The whimsical way economic policy is currently being made in the US may be helping to flatten the yield curve.
  • Inflation has been rising, but not to outrageous levels. Its long term outlook is modest. That can anchor longer rates.
  • Corporate sector indebtedness may be acting as a brake on the rise of the ten year yield. Corporate America is highly indebted, almost as indebted as it has ever been. Interest rates are low so it’s easier to carry this burden than it would have been a decade or two ago, but the market may be getting concerned. (More on that in an upcoming post.)

NonFiCorpDebt2GDP

It is possible that the yield curve is heading towards a recession signal, but there may be other reasons the yield curve is flattening. No question that it should be watched, just realize that no one outcome is inevitable.

 

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