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For all the models economists rely on, the most successful method of predicting recessions to date has been the yield curve - specifically inverted curves, which have preceded every recession since the Second World War. It’s therefore unsurprising that a flattening yield curve is starting to capture the attention of cautious investors wary of inflated asset prices this deep into the business cycle. This caution has resulted in increased volatility, along with sizable corrections in the equity markets as all major global indices witnessed a negative quarter despite robust earnings and a backdrop of macroeconomic growth.
Inverted yield curves are uncommon, occurring when short-term interest rates exceed longer-term rates. This is because as well as being a predictor of future interest rates, long-term rates should include a risk/term premium to compensate for the uncertainty of future inflation and its ability to erode real returns. As such, inverted as well as flat yield curves are taken as an indicator that future interest rates will be lower in order to provide a stimulus to counter poor, if not negative, economic growth.
In the US, the difference between the ten year and two-year Treasury yields has fallen to as low as 50bps (as it has in the UK). This flattening of the yield curve has largely been driven by increases at the short end, with the Fed normalising interest rates while a synchronised period of domestic and global economic growth allows. The result has been five consecutive quarters in which the target range for the Federal Funds rate was raised. At the most recent of these, last month, the Fed also updated its projected growth figures – the consequence being that the committee’s ‘dot plot’ now only narrowly shows a median expectation of three hikes in 2018 rather than four, with a further three pencilled in for 2019.
On the face of it, the rate of hikes implied by the Fed might be mistaken for utter disregard for the yield curve and its apparent ability to predict a future recession. However, there are a number of reasons to believe that the predictive nature of the current yield curve is limited. Firstly, while central banks have historically used their projections and comments to influence the full length of the yield curve, they have only had direct control over the short end – the rest being determined by market forces. This has not been the case since the unprecedented explosion in central bank balance sheets following the financial crisis. It is widely accepted by economists that these asset-purchasing programs artificially suppressed the 10-year treasuries by approximately 100 bps. While central banks appear increasingly committed to reducing their balance sheets, these plans are currently relatively modest and, as such, long-term rates remain suppressed, resulting in a relatively flat yield curve – at least for now. Nobody truly understands what influence unwinding such programs will have, but it is not unrealistic to think it will lead to upward pressures.
Secondly, longer-dated treasuries arguably suffer from increased demand as current regulations encourage large financial institutions to hold significant allocations. That said, this relationship may break down going forward as we see an increase in the supply of government debt in order to fund a burgeoning budget deficit in the US.
Thirdly, economists and central bankers, including Yellen, have long argued that the yield curves for advanced nations like the US, UK and Eurozone will likely be flatter in the future as the long-term economic growth prospects are limited by ageing populations and a higher savings ratio.
Finally, there are only modest signs of future inflationary pressures, with markets giving the impression that they are content that central bank policies will suffice in managing, if not stifling, such pressures. Yet the crux of this point is dependent upon one’s perception of the Phillips curve. While many have called for the death of this theory as wage growth has failed to keep pace with falling unemployment, it would appear from Powell’s hawkish persuasion that the Fed remains confident in the relationship between unemployment and inflationary pressures if not openly surprised by the lag in wage growth to-date. As such, with the Fed predicting unemployment will fall to 3.6% in 2019, they see sizable inflation risk that needs addressing despite the shape of the yield curve. However, the direct speaking Fed Chairman has made clear that he is open to updating this opinion as new information becomes available. As a result, one could expect the shape of the yield curve to become an increasingly important element of the debate were inflationary pressures not to surface as projected.
Turning to the UK, similar considerations apply, but with the additional pressure of the ongoing uncertainty around Brexit causing the GBP yield curve to be flatter than it might otherwise be. The market’s perception is that weak domestic growth will limit the Bank of England’s ability to normalise monetary policy.
Whether in the US, UK, or Eurozone, the ‘correct’ shape of the yield curve, in particular, its flatness, is going to be subject to increasing levels of debate, and rightly so. However, while stating the obvious in that the yield curve will certainly be wrong in projecting long-term interest rates, we would cautiously suggest the curve has potential to steepen further, which will, in turn, drive further volatility.
Upcoming Economic Releases
Looking to the week ahead, Wednesday should see welcomed inflation and unemployment data being released in the Eurozone. Inflation figures for March are expected to show an increase from 1.1% to 1.4% which will be welcomed following three consecutive months of falling inflation whilst unemployment should have fallen in February. PMI for both the UK and Eurozone will likely come in a little softer as the recent bad weather temporarily weakens sentiment. On Friday, we have the non-farm payrolls in the US, which should underscore the relative strength of the labour market although at a slower rate than the February numbers.
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