Is the US yield curve sounding an alarm?

The US yield curve – one of the best market indicators of looming recessions – has flattened dramatically this year. Chris Rands, a portfolio manager at Nikko AM, looks at what the yield curve is telling us.

Over the past six months the US yield curve has continued its flattening trend after steepening during the second half of 2016. The US 2/10 curve, which is the US 10 year yield minus the 2 year yield, has fallen to around 90 basis points and is now well below the 265 basis point peak seen in 2013.

Investors should be wary of a flattening yield curve as it may signify a slowing economy while an inverse curve (i.e. 10 year yields below 2 year yields) has historically been the harbinger of recessions. The significance of the curve matters as long term bonds can be thought of as a series of rolling short term bonds.

When the longer term maturities fall below the short term maturities it signifies that investors believe short dated interest rates are too high and would prefer to lock in the longer term rates now. Over the past 30 years an inverse yield curve has occurred three times and all of these occurred during a tightening rate cycle. This includes 1988 during the US savings and loans crisis, in 2000 prior to the dotcom crash and in 2006 prior to the global financial crisis.

Any further flattening from here is going to raise warning signs for investors and create comparisons to previous recessions. However given the yield curve is currently positive, we can also draw some other conclusions from this signal.

The first signal is that the bond market is telling the US Federal Reserve that it does not believe the Fed’s current expectations for the cash rate trajectory. Using the dot plots from the Federal Open Market Committee we observe that the Fed members expect a median cash rate of 2.125 per cent in 2018 and 2.94 per cent in 2019, implying another eight hikes through to 2019.

If the Fed were able to achieve this without causing a recession, the US 10 year yield should be over 100 basis points higher, as investors could hold cash at 3 per cent rather than take the maturity risk of a 10 year security significantly below cash.

The second signal is that the US 2/10 year curve has historically flattened when the Fed was hiking interest rates and tightening financial conditions. This has been the case for every hiking cycle since 1990 and ends when the Fed begins cutting interest rates. Given the US 2/10 curve started flattening when quantitative easing ended, this likely means that taking away this stimulus was indeed tightening monetary conditions and that the current tightening cycle has been in place for longer than the typical investor believes.

The third conclusion is that while the curve is flattening, it is not yet at levels normally associated with a recession. The US 2/10 year curve spent 1994 to 1998 ranging between 0 to 60 basis points and it wasn’t until it finally inverted that it signalled the end of the cycle. The main difference over this period was that cash rates were biased lower and the curve didn’t invert until the Fed started taking rates higher.

Given the Fed’s insistence on raising interest rates it’s hard to envisage the curve staying in this range while they sit on their hands. Thus, while there is no clear signal yet, if the Fed keeps hiking interest rates and the curve inverts, this should be a warning signal to investors to be wary about where we are in the economic cycle.

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