The flattening yield curve has sounded alarm bells in the bond market, raising fears of an increased possibility of recession in the near future. These fears are largely unfounded. When investors speak of a flattening yield curve they are referring to the tightening spread between short term and long term interest rates. Typically the spread between the 2 year treasury rate and the 10 year treasury rate (2s10s spread). A flattening yield curve may eventually become an inverted yield curve, implying the yield on short term rates will be greater than long term rates. This is a problem because it signifies the end of the short term debt cycle, a concept used by Bridgewater's Ray Dalio. The short term debt cycle involves the relationship between the growth rate of money and credit (or spending) versus the growth of the quantity of goods and services produced (capacity). Most spending is driven by increases in credit. For the private sector to generate credit growth, both borrowers and lenders must believe in a win-win scenario. Lenders with a surplus of capital must believe they will get paid back plus interest payments within a predetermined time range. They must be better off than if they had simply invested their money in inflation hedged assets. Debtors must believe their ability to repay the loan plus interest is at least as great as the value of the assets they are acquiring. The short term debt cycle is in an expansionary phase when the growth rate of money and credit is greater than the ability of the economy to produce goods and services. If the supply of money and credit is going up faster than the quantity of goods and services, prices increase, sparking inflation. In order to tame inflation, central banks are compelled to raise short term interest rates. Higher short term interest rates will drain liquidity, and tighten credit conditions since money is no longer so easy. The decrease in the growth rate of spending (mainly driven from a decrease in growth rate of private credit) will eventually fall below the growth rate of goods and services production. This creates a deflationary environment. In a deflationary environment inflation expectations decrease, prices fall, and long term bond yields decrease. These dynamics cause a recession because falling prices involve an environment where borrowers are no longer willing or able to borrow and lenders have no incentive to lend - economic activity contracts. This dynamic will persist until the central bank is forced to lower short term interest rates which will lower debt service costs, create a wealth effect for income producing assets, and incentivize both lenders and borrowers to create credit. The win-win scenario is rediscovered and the short term debt cycle kicks off again.
If the US bond market is headed to an inverted yield curve, is there a likely recession on the horizon? I do not believe so. The 2s10s spread has tightened from the +180-190 bps range in September 2011 to the mid +60 bps range today. This is the tightest spread since the years before the financial crisis, an ominous sign. The fear is that the Fed will continue to increase short term rates in accordance with their dot plot. The yield curve will invert, sending the economy into recession. The primary driver of the flattening yield curve has been the dramatic increase in short term rates. From September 2011 to today, the 2 year treasury rate has increased from 15 bps to 175 bps. This is the part of the yield curve where the Fed is able to exert the most influence since it is closest to the Fed Funds Rate that the Fed directly controls. The low level of unemployment and building wage pressures have justified these Fed rate hikes, despite a hiking phase that has been more gradual and longer than any investor would have expected years ago. The lack of any major disruption to financial markets or the real economy has provided comfort for the Fed to continue this rate hiking cycle. The long end of the yield curve is influenced more by long term growth and inflation expectations. Even though the Fed has been hiking short term rates, they have consistently lowered their long term estimate of the neutral rate. This lower neutral rate is derived from lower long term growth and inflation expectations, thereby lowering long term bond yields. These two dynamics interplay to create a flattening yield curve.
US growth has been stronger than expected in 2017, which has boosted Fed rate hiking expectations, and thus increased short term yields. The Fed maintains belief that the Phillips curve is not completely broken and that inflationary pressures are likely to build, paving the way for further rate hikes in 2018. Bond traders do not agree. They foresee lower long term growth potential and lower long term inflation expectations, meaning lower long term interest rates. If these dynamics were the only factors at play, the Fed may very well be at risk of inverting the yield curve. However there are important external factors influencing the yield curve during the post financial crisis era that need to be examined. Global financial markets have been integrated over the years as foreign capital is able to move freely across borders for less cost. Although quantitative easing is winding down in the US, it is still in full force in regions like Europe and Japan. The ECB and BOJ have kept their short term interest rates in negative territory. Growth and inflation dynamics in these economies are even lower than in the US. So low that global long term interest rates create a cap on long term US interest rates. If a European investor can gain a yield advantage by buying a US treasury for 240 bps and greater liquidity than a German Bund at 40 bps even after hedging costs, that is an easy decision to make. These lower global inflation and growth dynamics in Europe and Japan underpin QE programs in these regions. It is likely their QE programs continue for several more years. The key dynamic to watch in 2018 will be the bear flattening caused by the Fed increasing short term rates and the bull flattening of long term interest rates driven by global QE. Despite low levels of growth and inflation in the global economy, 2017 has been a year of synchronized growth across the world. After years of tepid inflation, spare capacity has diminished, the commodity price downturn appears to be over, and there is growing onus on politicians to boost wages. These factors can finally drive inflation higher. This can raise global bond yields, raising the cap on US long term yields, and reverse the flattening effect on the US yield curve (or at least prevent the curve from inverting).
For a recession to occur, money and credit need to dry up. Despite high debt levels, corporations with low credit rating have had little trouble accessing the capital markets this year. The US banking sector is still healthy and well capitalized. Despite the end of QE, the Fed is still reinvesting coupons and maturities, creating more liquidity. Short term interest rates are still nominally low, credit conditions are not yet tight. Equity markets may be in over valued territory but the earnings outlook looks robust. If global QE is still ongoing, money and credit are still being pumped into the financial system. Given the demand for income producing assets, credit appears far off from actually harming economic growth (even if the risk in credit markets has become quite asymmetric). If these factors persist, inflation expectations should increase, alleviating the flattening nature of the yield curve. Growth and inflation expectations have trended stronger in Europe, so look for details of an ECB QE unwind in 2018 as a major catalyst for a steepening yield curve in the US. Even if inflation continues to disappoint - the Fed will react to the data. They can revise the dot plots down, as they have done so many times over the past couple years.
Finally the term premium. The term premium is the extra yield investors receive to compensate for investing farther out the yield curve. This extra compensation is reasonable given the greater uncertainty for the path of short term rates over the long term. Thanks to the Fed's forward guidance, and global bond markets pulling down long term US interest rates, the term premium has been sucked out of the bond market. The term premium, and therefor the spread between shorter and longer term rates has nowhere to go but up. For all the fret and worry about a flattening yield curve, as the Green Bay Packers quarterback Aaron Rodgers once said after his team's 1-2 start to the NFL season, "R-E-L-A-X."
If the US bond market is headed to an inverted yield curve, is there a likely recession on the horizon? I do not believe so. The 2s10s spread has tightened from the +180-190 bps range in September 2011 to the mid +60 bps range today. This is the tightest spread since the years before the financial crisis, an ominous sign. The fear is that the Fed will continue to increase short term rates in accordance with their dot plot. The yield curve will invert, sending the economy into recession. The primary driver of the flattening yield curve has been the dramatic increase in short term rates. From September 2011 to today, the 2 year treasury rate has increased from 15 bps to 175 bps. This is the part of the yield curve where the Fed is able to exert the most influence since it is closest to the Fed Funds Rate that the Fed directly controls. The low level of unemployment and building wage pressures have justified these Fed rate hikes, despite a hiking phase that has been more gradual and longer than any investor would have expected years ago. The lack of any major disruption to financial markets or the real economy has provided comfort for the Fed to continue this rate hiking cycle. The long end of the yield curve is influenced more by long term growth and inflation expectations. Even though the Fed has been hiking short term rates, they have consistently lowered their long term estimate of the neutral rate. This lower neutral rate is derived from lower long term growth and inflation expectations, thereby lowering long term bond yields. These two dynamics interplay to create a flattening yield curve.
US growth has been stronger than expected in 2017, which has boosted Fed rate hiking expectations, and thus increased short term yields. The Fed maintains belief that the Phillips curve is not completely broken and that inflationary pressures are likely to build, paving the way for further rate hikes in 2018. Bond traders do not agree. They foresee lower long term growth potential and lower long term inflation expectations, meaning lower long term interest rates. If these dynamics were the only factors at play, the Fed may very well be at risk of inverting the yield curve. However there are important external factors influencing the yield curve during the post financial crisis era that need to be examined. Global financial markets have been integrated over the years as foreign capital is able to move freely across borders for less cost. Although quantitative easing is winding down in the US, it is still in full force in regions like Europe and Japan. The ECB and BOJ have kept their short term interest rates in negative territory. Growth and inflation dynamics in these economies are even lower than in the US. So low that global long term interest rates create a cap on long term US interest rates. If a European investor can gain a yield advantage by buying a US treasury for 240 bps and greater liquidity than a German Bund at 40 bps even after hedging costs, that is an easy decision to make. These lower global inflation and growth dynamics in Europe and Japan underpin QE programs in these regions. It is likely their QE programs continue for several more years. The key dynamic to watch in 2018 will be the bear flattening caused by the Fed increasing short term rates and the bull flattening of long term interest rates driven by global QE. Despite low levels of growth and inflation in the global economy, 2017 has been a year of synchronized growth across the world. After years of tepid inflation, spare capacity has diminished, the commodity price downturn appears to be over, and there is growing onus on politicians to boost wages. These factors can finally drive inflation higher. This can raise global bond yields, raising the cap on US long term yields, and reverse the flattening effect on the US yield curve (or at least prevent the curve from inverting).
For a recession to occur, money and credit need to dry up. Despite high debt levels, corporations with low credit rating have had little trouble accessing the capital markets this year. The US banking sector is still healthy and well capitalized. Despite the end of QE, the Fed is still reinvesting coupons and maturities, creating more liquidity. Short term interest rates are still nominally low, credit conditions are not yet tight. Equity markets may be in over valued territory but the earnings outlook looks robust. If global QE is still ongoing, money and credit are still being pumped into the financial system. Given the demand for income producing assets, credit appears far off from actually harming economic growth (even if the risk in credit markets has become quite asymmetric). If these factors persist, inflation expectations should increase, alleviating the flattening nature of the yield curve. Growth and inflation expectations have trended stronger in Europe, so look for details of an ECB QE unwind in 2018 as a major catalyst for a steepening yield curve in the US. Even if inflation continues to disappoint - the Fed will react to the data. They can revise the dot plots down, as they have done so many times over the past couple years.
Finally the term premium. The term premium is the extra yield investors receive to compensate for investing farther out the yield curve. This extra compensation is reasonable given the greater uncertainty for the path of short term rates over the long term. Thanks to the Fed's forward guidance, and global bond markets pulling down long term US interest rates, the term premium has been sucked out of the bond market. The term premium, and therefor the spread between shorter and longer term rates has nowhere to go but up. For all the fret and worry about a flattening yield curve, as the Green Bay Packers quarterback Aaron Rodgers once said after his team's 1-2 start to the NFL season, "R-E-L-A-X."
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