What is Driving the Shape of the Yield Curve?

Since February 2011 when the spread between 2-year and 10-year treasury notes peaked at roughly 285 basis points, market participants have watched the seemingly inexorable march to a flatter yield curve which now stands at around 20 basis points of spread for the same 2’s – 10’s relationship. Historically speaking, significant or persistent curve flattening occurs when the Federal Reserve raises the overnight Funds rate in response to very low unemployment and /or higher inflation. Such is the case now as the Fed has raised short rates seven times since December 2015, even though inflation has been fairly well behaved.  Traditionally, when the yield curve inverts, an economic recession usually follows.

The issue at stake is will the yield curve invert, and if so, is it a signal that an economic recession is imminent? A brief look at past periods of curve inversion may prove enlightening. Since 1983 there have been four curve inversions as measured by the 2’s -10’s spread. Three of these were followed by a recession within 12-24 months of initial inversion. In 1998 the curve inverted briefly (only a mild inversion) without a recession. Looking back even further, there were other periods of inversion without a recession but generally speaking in the past 40 years, inversion precedes recession. Clearly this history is not lost on members of the Federal Open Market Committee as it has become a debated issue. The market expects the Fed to raise rates at the upcoming September meeting, again in December and is currently projecting one additional move in 2019, while the Fed has projected 2 more moves in 2018 and 3 moves in 2019.

Part of the inversion equation relates to the long end of the curve and the markets’ perception that future inflation is not going to be a problem (TIPS as an indicator). Therefore, long rates have remained low, aggravating the potential 2’s -10’s inversion. Additionally, supply/demand imbalances in long treasuries has kept a lid on long treasury rates.  This is due to demographics and the demand for long duration assets from pension plans coupled with less treasury supply. 

Voting Atlanta Fed President Bostic went on record saying that he would not vote to hike if it meant inverting the curve. Bullard (St. Louis), not a voting member, recently said that the Fed should not “challenge” the yield curve (to invert with rate hikes) yet Chairman Powell is currently endorsing the gradual rate hike strategy.  What is interesting is that the 2’s – 10’s spread relationship gets all the attention, but perhaps Fed officials are referring to the Fed Funds rate versus the 10-year spread relationship.  If that’s the case, the Fed has a much longer runway to continue to raise rates as the Funds rate stands at 1.75 – 2.00% and the 10-year treasury is at 2.85%.  Based on the current spread relationship, it appears the Fed has room for 3 to perhaps 4 additional hikes before the curve inverts, should the 10-year rate not move higher from current levels.

In addition, much has been written about the “natural” or neutral Fed Funds rate that the Fed is targeting. It has become more topical in recent years because of its long-term downward trajectory and the implications that it has for the Fed and the future “Zero Interest Rate Boundary”. Currently, the Fed is trying to move the funds rate up to the perceived neutral long-term rate. Many analysts considered this to be 2.50% or higher. In this context, the Fed is still accommodative at 1.75 – 2.00% and “QE”, while tapering down, is also still an accommodation. Generally speaking, a restrictive monetary policy would be a cause for recession and Fed actions are not restrictive yet. Current economic growth seems supportive of that.   

It is hard to say “this time is different”. However, there are some new factors affecting curve dynamics. Given the Fed’s transparency, coupled with strong long end technicals and tepid inflationary pressures, it is possible to have a mild curve inversion which does not presage a 2020 recession.  Although an inverted yield curve does not fall under the Fed’s stated mandate, they should be in tune with the shape of the curve and with market expectations.  As the curve flattens and even inverts, the market is providing a clear signal of slower economic growth expectations.  Given the current flatness of the curve, the Fed should not actively increase rates beyond 3 more moves unless market expectations of inflation rise, and long rates increase.

 

Robert Fernald

Portfolio Manager

Boyd Watterson Asset Management, LLC

 

 

The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.