Flattening US Treasury Yield Curve: Should Investors Worry About It? December 26, 2017
In this article, we would like to take a closer look and share with investors our opinion regarding the recent trend of the US treasury yield curve.
Author : Sherman Tam Cheng Wei

Flattening US Treasury Yield Curve: Should Investors Worry About It?

Recently, financial markets are awashed by the news of flattening US treasury yield curve which has raised concerns among investors and attracted growing attention because, historically, such flattening preceded economic slowdown.

In this article, we would like to take a closer look and share with investors our opinion regarding the recent trend of the US treasury yield curve.

Understanding the yield curve

The yield curve is a graph which plots the relationship between yields to maturity and a group of bonds from shortest to longest maturity. It refers to the difference between interest rates on long-term versus short-term bonds. The reasons for the shape of the yield curve are many and complex where it comprises inflation expectation, expectations on the future economy prospects or foreign demand for debt. To put it simply, the yield curve measures the spread between the short- and long-term debt. Analyst and investors often pay attention into the yield curve as changes in yield curves may provide clues to financial market conditions as well as the harbinger of the future interest rates and economy.

Generally, long-term bonds pay higher interest rates compared to short-term bonds since investors are locking up their capital for a longer period of time – which represents a normal yield curve. A positive or upward-sloping yield (normal) yield curve signals that investors are optimistic on the future economic growth and putting a higher expectation into future inflation rate whereas an inverted or downward-sloping yield curve indicating investors expect a sluggish economic growth and expect a lower inflation in the future. For this discussion, we will be referring to the yield curve for US treasuries.

FIGURE 1: Inverted yield curve is recession predictive.

The shape of yield curve has gained some spotlight as a predictor of economic growth. The rule of thumb here is that an inverted or downward-sloping yield curve indicates an impending recession (see Figure 1). One of the recession predicted by the yield curve was the Global Financial Crisis. The yield curve was inverted in August 2006 (-0.1%), a year earlier before the recession started in December 2007. The curve also preceded the economic recession from March 2001 to November 2001 with an inverted yield curve of -0.20% in July 2000. The phenomenon, in which the yield curve is flattening right now, has caused some jittery among investors, who know it is historically an indication of recession.

What is going on?

To get a sense of just how substantial the change has been, we have taken a look into the current yields and compared that to those yields’ level 2 years ago. Figure 2 shows the magnitude of the changes in the slope of the yield curve while Figure 3 illustrates the changes in basis points across the treasuries with different maturities.

FIGURE 2: The flattening US Treasury Yield Curve.
FIGURE 3: Change in basis points (2015-2017).

What is going on?

1. Federal Reserve’s rate hiking pushes the short-term rate

Given that the US economy is now experiencing a prolonged economy expansion and improving labour market, short-term interest rates moved higher as a result of the Federal Reserve hiking its federal funds rate (see Figure 4). It has been 2 years since the Fed first increased their short-term interest rates in a decade. With five hikes now, the yield in the 3-months treasury has surged to 1.18 percent, up from 0.15 percent back in end-2015. In its latest FOMC statement, the Fed has signaled there could be three more hikes in 2018. The Fed has been communicating its intention to increase interest rates from close to zero level to a target rate of 2.5% over the next few years given the conditions of solid labour market and a 2% target inflation rate. We opine that the narrowing yield spread between 3-month notes and 30-year bonds was mainly attributable to the increase in yields on the shorter maturity securities as the policymakers in the Fed have lifted their benchmark interest rate.

FIGURE 4: Federal Reserve’s rate hiking pushes the short-term rate

2. Inflation is missing in action

Despite Federal Reserve’s rate hiking moves, the longer-term interest rates have not followed suit. The Fed has lesser control over long-term rates, such as the 10-year or 30-year treasury yield, which are affected not only by forecast for the Fed’s monetary policy decisions but also by expectations for future inflation and economic growth. The 10-year and 30-year treasury yield is close to where it ended two years ago, with just a change of 26 and -10 basis points (see Figure 3) respectively.

A flattening yield curve indicates the market believes that the Fed has set their short-term interest rate too high without the improving inflation data. This has make the market to expect a lower inflation in the future. If the trend persists and short-term rates go higher than long-term rates, it would create what investors call an inverted yield curve. That would be the signal that the bond market is expecting a weaker economic growth moving forward.

FIGURE 5: Federal Reserve Bank of Atlanta Wage Growth Tracker

One of the reason for longer-term yield being sluggish is the stubbornly low inflation. While seeing signs of a tight labour market, the wage gains are still only modest, hovering around 3.4%, which is still far away from about 4% before Global Financial Crisis and 5% before the Dotcom bubble. We believe the lagging productivity growth in US may have contributed to this phenomenon. Productivity growth has been soft since the end of financial crisis when compared to the previous recovery during economic expansions. While wages can temporarily outpace productivity growth, in longer terms, employers are unable to raise wages unless they are matched by higher production as it becomes unprofitable to keep employing those workers.

3. ECB’s debt-buying spree

FIGURE 6: US 10-year Treasury is more attractive than Germany’s

While the Fed rate hike has contributed to the flattening of the yield curve, there is another part of the story which explains why we are not seeing a synchronized upward lift in longer-term yields, which should “normalize” the yield curve as oppose to what is occurring now. Major central banks namely the European Central Bank and Bank of Japan are ongoing with their massive bond buying program have pushed the yields of the bonds lower. As such, their bonds are actually paying nearly nothing in interest (or negative yields), making investors to flock into US long-term treasuries to seek for yield. That in turn has made the US treasury yield curve flatter than it would otherwise be.

What do we think

All in all, we think that the flattening US treasury yield curve shouldn’t be on investors’ list of things to worry about as the flattening of the yield curve today is actually reflecting the aftermath of Fed’s moves as well as investors’ preference towards the US bond market. In the meantime, we do not see a recession looming on the horizon, given with the robust economic growth and solid labour market in US. This bond market signaling does not mean it is time for investors to rush out of risky assets, but it does suggest the economy is relatively closer to the end of the business cycle than the steep yield curve seen in the early days of post-crisis periods.

While we are in the midst of rising interest rate environment, we continue to advocate investors not to neglect bond funds as their portfolio stabilizer. Investors might consider short duration bond funds – AmIncome Plus if they are seeking for shelter from the volatility and uncertainty seen in financial markets in recent times.

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