The yield curve is one of those indicators that most people have heard of but few can explain. In part this is because it's usually a non-issue, only becoming important enough to argue about during the final year of long expansions.
(MarketWarch) - The yield curve flattened this week after the Fed minutes suggested that the December rate increase was a near-certainty, even as senior central bankers held concerns about lackluster inflation. The yield curve refers to the line drawing out a bond's yield and its respective maturities, with a flatter slope signifying weaker growth outlook.
The spread between the 2-year yield and the 30-year yield, one gauge of the curve's steepness, narrowed to 0.60 percentage point, the tightest span in a decade.
(Zero Hedge) - The US Treasury yield curve collapse continued its unending path to inversion overnight with 2s10s plunging to sub-60bps and 5s30s hits a 65bps handle for the first time since Nov 2007.
2s10s has flattened for 3 days straight, 6 of the last 7 days, and 14 of the last 17 days to a 58bps handle…
As a gentle reminder to all those shrugging this off, BofA reminds that in seven out of seven occasions in the last 50 years an inverted yield curve has been the prelude to recession.
In fact, the last four times the US yield curve was at these levels, the US economy was already in recession.
(Zero Hedge) - Currently, the top corp tax rate in the US is 35%. It looks most likely that rate will drop to 20% when tax reform passes. If you are a corp with an underfunded pension fund, you get a tax incentive to fund the pension THIS YEAR vs in the future when the corp tax rate drops to 20%. Why? Because contributions to the pension plan are tax deductible. You get a bigger tax deduction in 2017 then you will get in 2018 and onwards (assuming tax reform happens in something close to its current form…which it looks like it will).
Multiple primary dealers have reported pension buying in the 30yr sector over the past month, and coincidentally, 30yr bonds have rallied while the front end has sold off for the past month. Pension funds have a favorite bond to buy…STRIPS (30yr zero coupon bonds - higher yield than normal coupon bonds, better asset/liability match..more price sensitive to changes in yield…bigger bang for your buck in a bond rally..and is a flattener to the yield curve). Pension funds don't trade very much….they tend to buy and hold.
So these flows will SIGNIFICANTLY flatten the 30yr curve…and that is exactly what we have been seeing.
US Treasury yield changes (basis points) since Oct 24, 2017
So, step 1, Mystery Solved.
But Wait, There's More. If corp pensions are buying 30yr bonds, they are also buying stocks, to keep their relative portfolio weights stable (explains the recent stock rally).
However, come Jan 1 2018, that buying will evaporate, and then DOWN GOES FRAIZER (Fraizer is the US stock market).
(Mint Partners' Bill Blain) - The flatter US curve is NOT sending a deep meaningful warning of looming recession. It's hiding something much worse….
The short-end of the US curve reflects what the Fed has done in terms of hiking rates. But, the long end of the US Curve (10-30) is being driven by very different forces. It has flattened because of interest rate differentials between the ZIRP rest of world and the rate normalising US, but also on the fact external investors effectively drive US rates because they are the forced buyers!
Ongoing QE distortions in Europe and Japan are still driving close to Zero domestic interest rates - forcing investors offshore. Global demand for duration partially explains why the US 10-30 curve appears to have flattened. The transmission effects of $5 trillion QE in last three years is a massive allocation towards US assets - which explains why the 10-yr is sticking round 2.5% and the term premium is negative. Remove these effects of global distortion and the US curve would look much steeper and cause far less fear, panic and mania than the yield curve doomsters perceive. Relax. The yield curve is not the thing to worry about.
That dark thing is inflation! Over the last 10-years - since the Global Financial Crisis - we've seen the main drivers of inflation stagnate across the board. (I've argued many times if you want to see inflation then look at financial assets.) While prices and inflation signals have flat-lined, the inflation Central Bank feared they would create through QE has been incubating in massively inflated real assets - stocks and bonds. My Macro Economist colleague Martin Malone reckons an inflation shock is now a 50% plus risk! He points out all the major inflation drivers are coming back on line.
• Global inflationary expectations have risen dramatically this year
• Inflation data - which was deflationary 5 years ago, then flat, has now accelerated towards more normal levels
• Real Asset Prices - particularly housing and real estate rose dramatically over last 3 years
• Risk Assets - like bond and stocks remain hugely inflated
• Oil and commodities prices are rising
• Jobs are being created around the world, and increasing number of countries now looking at supply side fiscal policy means wage inflation looks inevitable! The Philips Curve returns!
Malone has quantified all the inflation drivers and added them up. He reckons in inflation drivers haven't been this high since 2007! Ask anyone on the street about inflation and they'll tell you it's very real. Wages have stagnated for 10-years, but prices are clearly rising.
In other words, this time may or may not be different. Possible explanations for the flattening yield curve include:
- A typical late-cycle transition from positive to negative slope (i.e., yield curve inversion), which implies a recession and equities bear market in 2018.
- Temporary tax reform distortion, which, when reversed out, will cause an equities bear market in 2018.
- Massive global liquidity pouring into long-dated Treasuries, which means spiking inflation followed by, we have to assume, rising interest rates followed in turn by a stock and/or bond crash in 2018.
Seems like we end up in pretty much the same place regardless.