What The Flattening U.S. Yield Curve Is Telling Us

by: Richard Turnill

Key points

  • The U.S. Treasury yield curve has flattened to decade-lows, but the flatter curve is not a recessionary signal, in our view.
  • Equity market leadership experienced an aggressive rotation last week. U.S. third-quarter growth was revised up. The pound surged.
  • Solid November U.S. job market gains and wage inflation should allow the Federal Reserve to proceed with a rate increase later this month.

The U.S. Treasury yield curve has flattened for much of 2017, and spreads between long and short maturities recently narrowed to decade-lows. This is usually a late-cycle phenomenon indicating flagging growth - but not this time around, in our view.

U.S. Treasury yield curve, 2017 vs. 2016

U.S. Treasury yield curve, 2017 vs. 2016

Sources: BlackRock Investment Institute, with data from Bloomberg, November 2017.
Notes: The lines depict the slope of the U.S. Treasury yield curve on Nov. 30, 2017 (blue) and in the year-earlier period (green). The dots are positioned at maturities of one, two, three, five, seven, 10 and 30 years.

The yield curve compares interest rates at different maturities. Investors tend to focus on the spread between yields on two- and 10-year bonds. Ten-year yields reflect the market's growth and inflation outlook. The short end of the curve is mainly tied to market expectations for Federal Reserve policy rates. The chart shows how recent curve flattening between two and 10 years is primarily due to a rise in short-term yields. This shows greater market confidence in the Fed nudging up rates mainly due to the better growth and inflation outlook. It would be worrying if the curve had flattened because 10-year yields were falling on concerns that Fed policy tightening might crunch growth and inflation. Instead, low inflation expectations have kept rises in 10-year yields in check, while declines in yields on even longer maturities largely reflect strong foreign buying and demand from institutions seeking to hedge risk.

Sustained expansion rather than recession

We see a sustained global and U.S. economic expansion. Our BlackRock Growth GPS points to steady and above-trend developed market growth of around 2%. Such solid growth and a return of mild inflation expectations have kept the Fed on track to lift interest rates later this month and at least three more times in 2018, in our view. We believe the Fed is unlikely to cut the expansion short with its steady interest rate rises and balance sheet reduction. We see the current Fed Funds rate as well below neutral levels (neither easy nor tight), and monetary policy remains highly expansionary. Our analysis of economic slack gives us conviction that this expansion's remaining lifespan can be measured in years.

Today's flatter yield curve is not a recessionary signal, so what is it telling us? Much of this year's earlier yield curve flattening represented a reversal of the 2016 steepening that accompanied surging economic growth and inflation expectations after the U.S. presidential election. Markets had bet that fiscal stimulus and infrastructure spending would spur growth and inflation. Long-term yields jumped in response.

Those market expectations unwound over the course of 2017 when policy changes were slow to materialize and weak inflation readings became the big surprise. Persistent demand for long-term Treasuries pushed 30-year yields lower even as short-term rates rose. We could see long-term Treasuries rising a bit from here - but expect low-trend growth, plentiful global savings seeking income and other structural factors to keep them historically low.

Our outlook for growth and inflation supports our preference for equities, including cyclicals - despite the flat yield curve. Within U.S. fixed income, we like Treasury inflation-protected bonds over nominal government debt.

  • Equity market leadership experienced an aggressive rotation, from momentum to low volatility and from technology to banks. U.S. yield curve flattening took a pause. The U.S. Senate passed its tax reform bill.
  • Organization of Petroleum Exporting Countries (OPEC) members and non-members agreed to extend production cuts. North Korea tested a missile. The U.S. moved to block China's "market economy" World Trade Organization status.
  • U.S. third-quarter GDP growth was revised up by 0.3% to a seasonally adjusted 3.3% annual rate. U.S. consumer confidence climbed to a 17-year high. Eurozone inflation came in below expectations. The UK reportedly agreed to meet the European Union's Brexit bill demands. The British pound surged to a two-month high versus the U.S. dollar.

Global snapshot

Weekly and 12-month performance of selected assets:

Equities Week YTD 12 Months Div. Yield
U.S. Large Caps 1.6% 18.0% 20.6% 1.9%
U.S. Small Caps 1.2% 14.6% 18.6% 1.1%
Non-U.S. World -1.5% 23.7% 26.9% 3.0%
Non-U.S. Developed -0.9% 22.1% 26.1% 3.1%
Japan -0.3% 22.6% 23.0% 2.0%
Emerging -3.3% 32.0% 32.9% 2.5%
Asia ex-Japan -3.3% 37.6% 34.7% 2.3%
Bonds Week YTD 12 Months Yield
U.S. Treasuries -0.1% 2.3% 2.6% 2.4%
U.S. TIPS 0.1% 2.5% 2.6% 2.3%
U.S. Investment Grade 0.1% 5.9% 7.0% 3.2%
U.S. High Yield 0.1% 7.2% 9.2% 5.7%
U.S. Municipals 0.0% 4.7% 6.4% 2.4%
Non-U.S. Developed -0.3% 10.0% 9.2% 0.7%
Emerging Market $ Bonds 0.2% 9.6% 11.6% 5.3%
Commodities Week YTD 12 Months Level
Brent Crude Oil -0.2% 12.2% 18.1% $63.73
Gold -0.6% 11.6% 9.3% $1,281
Copper -2.4% 23.4% 18.0% $6,833
Currencies Week YTD 12 Months Level
Euro/USD -0.3% 13.1% 11.6% 1.19
USD/Yen 0.6% -4.1% -1.7% 112.17
Pound/USD 1.0% 9.2% 7.0% 1.35

Source: Bloomberg. As of December. 1, 2017.
Notes: Weekly data through Friday. Equity and bond performances are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon:

Table: Asset class views from a U.S. dollar perspective

This post originally appeared on the BlackRock Blog.