This is a quick note here that the yield curve has flattened to the point where two-year yields are only 25 basis points lower than 10-year yields. I have been predicting this outcome for several months and see this as a level to worry about the Fed’s ability to engineer a reversal. Some thoughts below
The 25 basis point prediction
I was just looking through the Credit Writedowns archives to see when I first started predicting we would get to 25 basis points by mid-year and I found this from March:
As I wrote last night, my timetable was for economic weakness to appear later. The weak data this early into the synchronized global growth phase has surprised me. But the fact that the Treasury curve has resumed flattening makes sense. The data call for it.
A string of poor data has stalled the march higher to 3% on the 10-year. Even assuming the weak data represent a pause in the synchronized growth acceleration, they make it harder to achieve 3% before the curve flattening from overtightening begins. In fact, I think the present flattening may just be the beginning of overtightening that I thought would happen late Spring.
I am still expecting a pancake flat – 25 basis points at most – curve by mid-year. Between now and then, we will need to see how the data shake out and whether the Fed is data dependent. Right now, the 2-year is up 2 basis points to 2.27% from when I wrote last night’s post-market piece. And the 10-year is at 2.81% up only 1 basis point. That’s another point of flattening.
I’ll get worried when we break below 50 basis points between the 2- and the 10-year. Right now, we are headed in that direction.
This posts suggests I made the prediction earlier. But I think this is a good quote to use as a jumping off point because I remember that I had been saying mid-year data weakness would be the trigger for flattening. What has happened instead is that we got early year data weakness followed by mid-year data strength. And the Fed has stuck to its guns on tightening, particularly because of the data strength.
So the flattening is entirely driven by the prospect of Fed overtightening. That contrasts to the prospect of Fed overtightening in the face of signs of economic weakness, as I had been thinking.
25 basis points versus 50 basis points
For me, we are at a worrying point. A flat yield curve is just a reflection of market expectations of a halt to future Fed tightening due to future economic weakness. The economy can operate in a flat curve environment for months, even years, without any problem. The 1990s are a perfect example. But when we get below 50 basis points, that’s a danger zone, a sort of tipping point where end of cycle dynamics begin to pop up.
25 basis points is even flatter. And basically at that level, a patch of poor data can invert the curve without the Fed’s doing anything. So the difference here is:
- Above 50 is fine though it is a sign of market worry
- Below 50 basis points is historically a marker that the cycle is nearing its end
- Below 25 basis points and the Fed has lost control of the narrative. Weak data could invert the curve without the Fed’s doing anything more
So, that’s where we are now.
And because this is occurring against the backdrop of strong US economic data and Fed hawkishness, it tells you that the market worry is about Fed overtightening. Nothing people like Philadelphia Fed President Harker say has dissuaded markets from their concern that the Fed will overtighten.
The Fed is sending markets the signal that it will not relent. There has been no change in Fed policy. In fact, the last policy statement by the Fed showed the likelihood of four rate hikes in 2018 as marginally greater than three. So the markets are understandably concerned that this leads us to recession.
This time is different?
I will leave you with this article from Jamie McGeever at Reuters today:
There is much talk about whether the predictive powers of the yield curve are waning, with a growing number of experts arguing its inversion no longer signals recession. “This time it’s different,” they say.
Why might things be different this time?
In a world where yields on large swathes of the European and Japanese sovereign bond markets are still negative, U.S. Treasuries are effectively high-yielding securities. Demand for 10-year paper at around 3 percent, in what’s perceived as the most liquid and safest market in the world, is huge.
Yields are also being compressed by the Fed’s bloated, crisis-fighting balance sheet. It’s being reduced ever so slowly, but the $4 trillion of bonds on the central bank’s books is still enough to cap any rise in 10-year yields.
Inflation has remained stubbornly low since the crisis and the second longest U.S. expansion in history hasn’t led to significant wage growth. Many say traditional relationships between growth and inflation have broken down thanks to technology, weak labour bargaining power, a more flexible labour market and the “gig economy”.
Are you comforted yet?
As Jaime says:
Given its past accuracy and the lack of alternatives, the yield curve is one of the few recession-forecasting tools economists have. Maybe it won’t be different this time after all.