Is the flatter US yield curve cause for concern?
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Is the flatter US yield curve cause for concern?

For the first time in a decade, the 2-year/10-year US Treasury yield spread has narrowed to less than 60 basis points (bps). The flattening has led to some investor concern since yield curves inverted, with the 2-year yield rising above the 10-year yield, prior to each of the past three US recessions.

Technical factors, rather than fundamentals, explain a lot of the flattening.

But while a flatter curve can indicate investor pessimism about the growth outlook, we do not believe this flattening is cause for investor concern at this stage:

  • Technical factors, rather than fundamentals, explain a lot of the flattening. First, quantitative easing programs have pushed 10-year term premiums into negative territory. We estimate the term premium was 1% ten years ago; today it is –0.45%. The term premium is the compensation that investors require to hold a long-term bond instead of a series of shorter-term bonds. Historically, this has been positive as investors want additional yield to tie up their money for longer. Second, with corporate tax cuts on the agenda, US corporates are pre-funding their pension liabilities to take advantage of the 35% tax deduction, increasing the demand for long-dated Treasury strips. And third, breaking from a policy in place since 2009, the Treasury will stop attempting to lengthen the maturity of the government’s debt. This could limit upward pressure on long-term interest rates from government issuance.
  • Structural changes that have held down long-term rates so far are likely to persist. Slower productivity and an aging population have reduced the neutral real interest rate, while inflation expectations have also been well-anchored close to the Fed’s 2% target. Meanwhile, at the short end of the curve, the Fed is raising rates, but only in response to strength in the economy, not high inflation. US GDP has just posted back-to-back quarters of 3% growth.
  • It isn't unusual for short- and long-term yields to move independently. In the 2004–06 hiking cycle, long-term rates fell from 7.3% to a low of 5.5% at the start of 2006. But yields then rose again to 6.75%, as tightening continued into June 2006. In the 1988–89 cycle, short-term rates were hiked by 325bps, but 10-year yields rose just 75bps, and were back where they started by the time rates were cut in June 1989. And in 1994–95, a 300bps increase in fed funds corresponded to a maximum rise in 10-year yields of just over 100bps. Yet once again, rates were back where they started when the Fed eased in July 1995.

Overall, we believe the flattening in the yield curve reflects a combination of technical and structural factors holding down long rates in conjunction with expectations of gradual Fed tightening, and not investor fears of a downturn. We see the whole yield curve shifting modestly higher, but also flattening slightly further. Our 12-month forecasts for 2- and 10-year yields are 2% and 2.5% respectively. We don’t expect this to prevent equities from grinding higher, and remain overweight global equities.

Bottom line

A flattening US yield curve, as short-term rates rise and long-term rates remain static, has raised concerns that it’s a precursor to a downturn. But we believe low long-term rates can be explained by a combination of structural and technical factors, while rising short-term rates reflect expectations for gradual Fed tightening amid good short-term growth. We stay overweight global equities.



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The slope of the curve reflects the synthetic appraisal from market participants of economic growth prospects. Its dwindling trajectory suggests that the current mix of monetary policy and fiscal reform guidelines has or will exert a net softening impact on growth dynamics in the Us. With 10-year Tbond yield stable at around 2.30%, sharply above German (0.40%) and Japanese (0.10%) similar tenures, dollar forwards already enable hedging Us export flows at a lower and more competitive level. Their corresponding Spot Fx rates around 20-year averages and subpar levels of fx volatilities do not point to a significant change in the terms of trade, which could temporarily alter the subdued inflation environment. The main risk that would further flatten the curve could be a surprising and sustained mark up of oil prices, fostered by a muted level of investment in the last 3 years and a robust increase in demand. It would lead to a curb on disposable income wich should dent household spending and further moderate growth. A neutral or accomodative monetary policy would then be required to prevent an inverted curve, the harbinger of an economic downturn.

Baruch Deutsch

Business Development | Capital Raising | Israeli & American Business / Tech

7y

Deflation - bad news!

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Asif Abdullah, CFA

Director - Pension Investments at Scotiabank

7y

While I do not see the flattening of yield curve as a cause of concern about recession, since I work for a Pension plan, decline in longer dated yield is very much a cause of grief. [Unlike many in your audience, I am happier when long yields go up]. I know that structural factors are not going away any time soon, so no relief there. But what about the technical factors, specially the buying pressure coming from corporate pensions as a result of expected tax cuts. I have seen a few others also pointing out to this factor as the reason why longer dated yields have come down recently. If that is indeed a significant reason, its effect should reverse quite quickly. So any thoughts on the magnitude of impact of incremental bond buying by pensions?

Carlos Terre

Group Managing Director Head of Commercial Management at Scope Ratings

7y

The curve is not a cause. It is a symptom. And, yes, this symptom is concerning. It is evidencing the actions of agents in the economy who are gradually deteriorating their liquidity. This means, likely, miss-allocation of capital and excessive risk being taken. It is now when crisis are cooked, slowly.

Warren Huang , PhD

Founder 50 yr Consultant, workshops China, global knowledge AI neural net, automation macro, sectors, biotech, supply chain optimization asset, debt bubbles, recession, knowledge debottleneck

7y

It is causes behind flatten concern US and global economy facing overheated asset, debt bubbles facing Minsky Moment due t income inequality, with bottom 90 % facing poor income at 1999 level , cutting into by high housing price, rent, and consumer spending, drag inflation, flatten bond yield, create GDP bottleneck, fail to support overvalued asset, debt bubbles facing collapse.

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