What does the flattening yield curve mean?

Peter Warburton - 26 July 2018

There was once a time when the flattening of the yield curve was a reliable – but never infallible – precursor to slowing economic activity. Today, we have bull flatteners (where long-term rates fall relative to short-term rates) as well as bear flatteners (where short-term rates rise to meet long-term rates) and there is no clear economic inference.  The emphasis has shifted from policy behaviour, influencing the path of short-term interest rates and rippling out to long-term rates, to investor positioning along the yield curve. Where will investors turn next? 

Figure 1 traces the seemingly inexorable journey of the 2-year-10-year and 5-year-30-year spreads towards the dreaded zero line. At the zero line, the carry trade is dead, risk is off and investors are meant to scurry to the refuge of long-dated Treasury bonds. The circular logic of today’s bond bulls requires that a near-3 per cent 10-year US Treasury bond yield represents the outer limit of what our highly-indebted economic and financial system can bear. As the 2-year yield (embodying the expected path of Fed funds rate increases over this horizon) rises towards this supposed boundary – often referred to as the terminal or neutral rate – then it is supposed that the economy will slow and that, within a short time, inflationary pressures will abate.  

However, the typical real interest rate achieved at the end of a post-war US tightening cycle has been 2, 3 or even 4 per cent. Today, it hovers around zero. How can we be sure that US real interest rates – short and long – will not revisit positive territory before the economic expansion ends? 

The alternative scenario, which we favour, is that the entire US yield curve has further to travel to adjust to an environment of faster nominal GDP growth. Not only could the FOMC extend its planned normalisation, in the light of positive economic surprises, but bond yields could create the room for that normalisation to occur in the context of an upward sloping curve. (Just imagine the Trump tweets that would ensue).

Tomorrow, the US Bureau of Economic Analysis releases the advance estimate of Q2 growth. It is not beyond the bounds of possibility that this could be a very strong figure – over 4 per cent real and over 6 per cent nominal. How would you wish to be positioned in the long-dated Treasury futures market if you entertained this suspicion? Or if you took the New York Fed’s underlying inflation gauge (figure 2) seriously? Or the Atlanta Fed’s wage tracker?  

Figure 3 provides a rough-and-ready answer. Aggregate net positioning, in terms of numbers of contracts, has never been as negative as it is today, with these positions concentrated in the longer maturities. Tariff talk has diverted financial market attention from the here and now. US yields have a meal to digest first. 

Figure 1

Data source: Eikon Reuters

Figure 2

Data source: US Bureau of Labor Statistics and New York Federal Reserve

Figure 3

Data source: CFTC

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