By: Jeff Pollock
January
8, 2018

Attention has been drawn in recent weeks to the flattening US yield curve.

In short, the yield curve is a chart that plots the maturity dates for various US Treasuries along with their respective interest rates. Its shape will adjust based on economic conditions and often predicts future recessions with decent accuracy.

When upward sloping, long-term bonds offer a higher yield than those in the short-term because of robust inflation and economic expansion. The opposite is true when the yield curve begins to flatten or – even worse – invert. In those cases, demand for long-term bonds increases (thus sending yields lower) due to weak inflation expectations and poor economic growth prospects.

The yield curve was flat at the beginning of 2007 (purple line). By the end of 2008, we were in the middle of the worst recession in a generation. Today, the present yield curve (green line) remains upward sloping.

However, today’s yield curve has flattened relative to its shape the day of the Presidential Election on November 6, 2016 (purple line).

We know why the short end of the curve has moved up. The Federal Reserve hiked rates four times since the Presidential Election. However, the long end of the curve has yet to move in either direction.

So, does this mean a recession is imminent?

Not necessarily, for these reasons below.

  • Inflation expectations have been low. If that weren’t the case, the long end of the curve would be higher. In recent days, inflation expectations over the next 10 years surpassed 2.0% (the same as the Federal Reserve’s target) for the first time since March 2017. Should inflation begin to accelerate, the yield curve will become upward sloping.
  • There has been strong demand for longer-term debt issuances made by the US Treasury. The first baby boomer is now 71 years old and possibly retired with a lower risk tolerance that requires bond securities within their portfolio. Furthermore, over $8 trillion of global bonds still accompany a negative yield. If these two factors were absent, demand for long-term US Treasuries would be lower and yields on the long end of the curve would be higher.
  • Following the Trump tax cuts, the IMF projects that the US will lead its G-7 peers with 2.3% GDP growth in 2018. Earnings results from Q4 kick off this week, and expectations are for 10.5% growth. For all of 2018, earnings and revenues are projected to grow 13.1% and 5.7%, respectively. Hardly a recession.

 

While the yield curve has flattened relative to its shape during November 2016, we do not believe it will invert this year. Should it flatten further, it is important to remember that mechanical factors that were absent in previous cycles are at work today. Nevertheless, we’re watching the trend develop and will be prepared to trade in accordance with our analysis for client portfolios.

 

 

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