US yield curve flattening: How should investor read this?

Anubhav Sahu Moneycontrol Research

Market is abuzz with talk about current US yield curve flattening and a potential US yield curve inversion scenario having an adverse implication for the economy and financial markets. While in the past they have had a signaling impact for impending economic slowdown, we feel factors governing this business cycle and impact of global central bank’s monetary policy may make the reading different this time.

Yield curve – what does it imply

Yield curve flattening - when the difference between yields of long-term maturity bonds and short-term bonds are narrowing, they are typically seen as a predictor of slowdown in economic growth. Similarly, yield curve inversion – when yields of long-term maturity bonds (typically 10 year) are lower than that of short-term bonds, is seen as a signal for impending recession. In fact, in the last seven recessions, an inverted treasury yield curve has preceded the crises.

Chart: USA 10 year yield minus 2 year yield and USA recessions

Central banks keep a predictive model based on yield curve

Federal Reserve Bank of Cleveland maintains a predictive model for GDP growth and probability of recession based out of yield curve slope. Its current reading highlights an 11.8 percent probability of recession in one year, which is slightly lower than August reading (12.5 percent). As a rule of thumb, it maintains that an inverted yield curve indicates a recession in about a year. In case of the last recession, yield curve inverted in August 2006, about five quarters before the start of the crisis. However, there have been two false positives in 1966 and 1998.

Yield curve flattening

While there is considerable predictive implication of the inverted yield curve, the flattening phases may not necessarily be negative for financial markets. Further, there can be considerable length of period when yield curve flattening continues.

We looked at past instances of yield curve flattening when difference in narrowing of yields was mainly driven by a sharp increase in short-term yields. S&P 500 in those occasions was flat to moderately positive. In the current yield curve flattening phase, market has run up decently and underscores the fact that other factors like the early stage of economic and earnings momentum are also in play.

US treasury provides extra yield and value

In rest of the developed markets, a substantial quantum of bonds (~USD 6 trillion) are quoting at negative yields and hence the number of investors in the developed world prefer US treasuries (10 years) for the extra yield. While this keeps the lid on the 10-year yield, an additional factor which helps now is the Fed’s balance sheet unwinding programme. An orderly unwinding of Fed’s USD 4.5 trillion balance sheet can keep yields stable in time to come, as well.

So while an inverted yield curve scenario would be precarious. The current phase of yield curve flattening has to be read in terms of business cycle primed by quantitative easing. Having said that previous cycles of flattening led by a sharp rise in short term rates indicate that equity returns can moderate. Hence, all important inflation numbers remain crucial which have been treading below the Fed’s expectations.

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