If you haven’t been paying attention to the persistent flattening of the U.S. yield curve, you’re way behind it.
Peter Cecchini, chief market strategist at Cantor Fitzgerald, calls it “the most important thing to have a clear idea about now.” Billionaire fund manager Bill Gross says we’re rapidly approaching a point at which the trend will induce an economic slowdown. Others claim it’s only natural, with the Federal Reserve raising short-term interest rates in the face of stubbornly low inflation.
To put it simply, the Treasury yield curve measures the spread between short-and long-term debt issued by the U.S. government. It’s the extra compensation that investors demand to lock away their money for an extended period.
What Your Peers Are Reading
No matter which theory of flattening you subscribe to, the world’s biggest bond market is sending a signal that traders can’t ignore. The longer the trend continues, the more likely its effects could spread to bank earnings and the real economy, while at the same time it would limit the Fed’s ability to respond when these risks emerge.
To get a sense of just how dramatic this trend has been, here’s a look at a handful of curve measures now versus the start of 2017. In trading Monday, they were all close to the flattest levels in a decade.
From two years to 10 years: 72 basis points, down from 125 From two years to 30 years: 119 basis points, down from 187 From five years to 10 years: 33 basis points, down from 52 From five years to 30 years: 80 basis points, down from 114
Everyone has their favorite theory for why this is happening and what it means for the economy and the markets, and all of them likely play a part so here’s a breakdown of each one:
It’s the Fed’s Fault
The simplest reason for the flattening comes from looking separately at what’s going on with short rates, the most sensitive to Fed policy expectations, and longer-term yields, which take their cues from the outlook for inflation and economic growth.
After years of balking at tightening monetary policy for fear of disrupting markets, Fed officials finally stuck to their plan in 2017, earning bond traders’ trust in the process. The two-year Treasury yield is at the highest level since 2008 as investors prepare for a rate hike in December, and begin to build up expectations for further increases next year.
With short-end yields climbing, the curve historically tends to flatten as longer-term rates rise more slowly. But since the start of 2017, 10-year and 30-year yields have actually declined. And the culprit behind that appears to be stubbornly muted inflation.
Even with U.S. jobs growth humming along and unemployment at the lowest level since 2000, the Fed’s preferred gauge of price growth was running at just 1.6% in September. It fleetingly rose above the central bank’s 2% target at the start of the year, but has since struggled.
This all raises the specter of what some call a potential “policy mistake” from the Fed.
That narrative “has ruffled a few feathers,” BMO Capital Markets strategists Ian Lyngen and Aaron Kohli wrote in a note last week. “Growth is moving at a solid clip and the labor market is ostensibly at full employment — so why aren’t we in an environment with a steeper curve and higher yields?”
Their conclusion is the Fed has built up a reputation as an inflation fighter. That means going forward, traders should expect a lower yield range for 10-and 30-year Treasuries than they might have otherwise.
Supply and Demand
Another factor pinning down longer-term yields: forced buyers, both in the U.S. and elsewhere.