Yield Curve Shrinkage

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by: Ivan Martchev

The 2-10 bond yield spread is a case of shrinkage. Last Friday, the 10-year Treasury rate closed the week at 2.38% and the 2-year Treasury note closed with a yield of 1.58%. That's a difference of 0.80%, or 80 basis points. In other words, the 2-10 spread is again shrinking, reminding us that a shrinking yield at the tail end of an expansion is as normal as certain side effects after swimming in a cold pool.

Ten to Two Year Bond Yield Spread Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The yield curve has shrunk so much that it registered its lowest point in nearly 10 years, at 75 basis points earlier in the week. Right after the November 2016 election, the 2-10 spread vaulted all the way to 134 basis points, so the decline since then reflects a very significant shrinkage. The yield curve was never this flat during the tenure of President Obama. Mr. Obama's shrunken 2-10 spread record was 76 basis points right after Brexit; so by that yardstick Mr. Trump faces a more shrunken yield curve than Obama.

About That Fed "Independence"

To be fair to Mr. Trump, his yield curve shrinkage is not necessarily his fault. Most of the cold water being thrown on Mr. Trump's yield curve comes from the Federal Reserve, which is in the process of unwinding its infamous $4.5-trillion balance sheet as well as hiking the Fed Funds rate that has now risen to 1.25%. These Fed Funds rate hikes came before the balance sheet unwinding - which I characterize as "quantitative tightening," albeit in baby steps. Fed Funds rate hikes affect the 2-year note yield more, while quantitative tightening affects the 10-year note yield more. Since the Fed Fund hikes came first, the 2-10 spread has been falling.

United States Central Bank Balance Sheet versus United States Fed Funds Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

In the past, before quantitative easing became part of the Fed's monetary policy, the yield curve would shrink on its own due to normal market forces. The 10-year yield would decline as the Fed Funds rate rose and the outlook for inflation and economic growth would deteriorate. This time the shrinkage seems significantly more "engineered," given the intricacies of quantitative tightening.

Observing the Fed's gargantuan balance sheet expansion since 2008, I have often thought about the words of one of my finance professors in graduate school who told our class more than once that in his opinion the office of the Chairman of the Federal Reserve carried more power over the economy than the office of the President of the United States. At the time, I dismissed his view as an amusing aside, but after 20 years in the trenches of the fascinating world of finance, I have to think my finance professor was right.

I think that if the Federal Reserve Board of Governors wanted to drive Mr. Trump out of office, or at least lean on the scales to affect the 2018 mid-term elections, they could adjust the rate of their quantitative tightening. Given the fact that such quantitative tightening happens at a time of non-existent inflation, one has to wonder what the Fed's true objective is, as the ultimate outcome could be rather deflationary.

United States Inflation Rate Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Of course, various Fed Governors have made the repeated point over the years that they are apolitical and that they always worry about the perception of how any Federal Reserve action may be perceived in the political context. Such Fed statements are all fine and dandy, but if one were to use the time-tested practice of taking all official statements, not just the Fed's, with a grain of salt, one could see the problem of concentrating that much power in what is in effect an unelected office. (For more on the political pressures and power of the Federal Reserve, see the December 14, 2016, MarketWatch column by Greg Robb, "Not Hero nor Zero: The Complicated Legacy of Alan Greenspan.)

European and Japanese Central Banks

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Appreciating the role of central banks as major countercyclical forces in the global economy, I have to say that I do not believe that most global central banks are truly independent. That is true for the Federal Reserve, the Bank of Japan, the European Central Bank, and especially for the People's Bank of China.

The world's major central banks opened a Pandora's Box with this quantitative easing business. I am not sure the Fed will close Pandora's Box at their present rate of quantitative tightening. My analysis tells me that the next big financial crisis is centered on China due to years of runaway credit growth that has driven the total leverage in their economy from 100% debt-to-GDP ratio to 400% in less than 20 years.

Watching the Fed, ECB, and BOJ balance sheets balloon by trillions surely does not make me feel good.

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