Yield-curve flattening: a bad omen?

17 November 2017

After equity markets saw one of their longest winning streaks for quite some time, a bit of push-back from nervous traders and investors was probably inevitable. As if our lead article of last week had jinxed markets into action - sure enough - this week saw the longest streak of falling global equities since March. Before we get ahead of ourselves here, we should point out that this '˜losing' streak means consecutive days of declining market value and not the actual amount that markets have lost - the actual decline has been a modest 1-2% across most regions. Still, no good mood goes unspoilt for too long, it seems.

Amid the worries we've seen about markets running too hot and valuation levels becoming unsustainably high, a market hiatus like this gives the bears (those expecting market declines or even recession) a chance to scout for evidence that all is not well. Unfortunately, it looks as though they've found some.

Over the past year, yields on two-year US Treasury bonds have risen around 0.7%, while yields on ten-year Treasuries have risen only 0.12%. In finance terms, this is called a flattening of the yield curve - a narrowing of the term spread (the yield difference) between short and long-term bond yields. Normal yield curves tend to slope upwards, as longer-term bonds come at a yield premium to those with shorter maturities, due to the longer lock-up until the bond matures. This '˜normal' situation is supposed to indicate market confidence in a country's short-term economic prospects (provided the yields aren't just high across the entire curve). Conversely, a flattened or (especially) inverted yield curve - where long-term bonds yield the same or less than short-term ones - indicates a lack of confidence.

Why does this matter? The yield curve is usually one of the more reliable general indicators of economic prospects (in the US at least). An inversion of the treasury yield curve has preceded every US recession since the 1960s (and there have been no '˜false alarms' - inversion but no recession - see the chart below - whenever the blue line has dropped below 0, recession soon followed). More than simply reflecting markets' verdict on the economy, the yield curve also has a big effect on bank profitability. Banks make money off the spread between short and long-term yields, borrowing or taking deposits at the short end and lending at the long. When the spread tightens, a major source of profit dries up, and with it the banks' lending ability. This cuts off financing to the real economy, choking opportunities for growth.

So, naturally the current flattening has many investors worried. Should they be? Short answer, not really. Long answer'¦

First of all, we should remind ourselves that this isn't a case of inversion or even complete flattening, the curve is just flatter than it was a year ago. And, while inversion may be a pretty reliable guide to growth prospects, relative flattenings aren't as much. At the beginning of 2016, the difference between 2 and 10 year treasuries fell to what was then its lowest in eight years. Much like now, many doomsayers gripped onto the news as proof of oncoming turmoil; unlike now, they had an almighty stock market wobble to back them up. But there was no disaster to be found. Both global growth and capital markets surged to extremely healthy returns in 2016, despite the yield curve continuing to flatten throughout most of the year.

We have to look at both the likely causes and effects of this particular flattening to see what it says about future growth prospects. Often yield curve movements are partly symptomatic of economic developments and partly influential on them - reflecting general economic expectations and causing actual changes through bank profitability.

We don't believe the flattening we're seeing at the moment is about markets expecting a downturn, but instead about the particular set up of the bond market at the moment. In Europe, the ECB's ongoing QE purchases have pinned the 10-year German government bonds (called bunds) down at around 0.4%. This, in turn, has a large effect on 10-year treasuries, as their subsequent price advantage over bunds (higher yields mean lower prices for those purchasing the bond) makes them more attractive. The same dynamic is also true in Japan, where their central bank has pinned 10-year government bonds at an even lower yield. This has effectively anchored the long end of the US yield curve down at its current level. Meanwhile, the Federal Reserve (Fed) is pushing up the short end of the yield curve through raising interest rates - with another rate hike expected in December. Like in many other areas, QE is somewhat of a game-changer for bond markets, and so we can't expect the same old indicators and dynamics to hold true.

That settles the question of cause, but what about effect? Even if the yield curve flattening isn't a vote of no confidence in the economy, it can still have a material impact through falling bank profitability. But again, QE could well have an effect here. As the Fed begins to unwind its own QE process and release its stockpile of assets, a tactical approach could help. Were they to disproportionately sell - or even just wind down purchases of - the bonds at the long end of the yield curve while maintaining their stock of short term bonds, this would effectively force a steepening, allowing banks to profit and thereby lend more credit to the real economy.

Of course, the Fed might not want to pursue that policy of '˜artificial' steepening. Indeed, a large part of unwinding QE is about removing central bank crutches and letting private credit creation take over. But, the point is that the central bank has these policy options available if it looks like their activity at the other end of the curve - through interest rates - is having a damaging effect.

Besides, the economy doesn't live or die by bank profitability. The entire reason why US rate rises are expected to lead a general global monetary tightening is because economic conditions do look favourable. Global economic resilience, a strong labour market (which should lead to wage growth) and good financial conditions could well pick up the slack where central bank support drops off.

The yield curve is a good tool for looking at economic developments, but we shouldn't think of it as an '˜omen'. At the moment, we don't see too much reason for concern. But, things could well change if the flattening turns into inversion. In that case, we may have to take another deeper look and also consider widening junk bond yield spreads; their jump upwards over the past week was equally welcomed by the bears. However, just as with the yield curve, we have seen similar moves over the past 12 months.

As discussed at length last week, equity markets are overdue a bout of volatility, after having reached all-time highs while trading at exceptionally low volatility. However, for a near term correction or general market consolidation to turn into a full-blown bear phase it would require a significant deterioration of the general economic outlook around the world. Such a scenario is not currently anywhere on the horizon and, to the contrary - as we discuss in the third article - global growth looks more resilient than it has for a long time.

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