Why QT Will Flatten The Yield Curve
This week, we saw an inversion in the yield curve, a long-standing precursor of a recession. The inversion was not in the traditional treasury curve but in the breakeven spreads. The spread between the 30-year breakeven rate and the 5-year breakeven rate inverted this week for the first time since 2008.
In this piece, I will discuss why the yield curve is flattening through the lens of the Federal Reserve Quantitative Tightening (QT) program. There are a lot of misconceptions surrounding the QT program and a flattening or inversion of the yield curve makes perfect sense once the composition of the Federal Reserve balance sheet is properly understood.
The balance sheet of the Federal Reserve is skewed towards short-term maturity treasuries. Many of the bond bears dislike long duration bonds because the Federal Reserve is selling bonds as if that means all bonds, so therefore, all rates must rise. This could not be more incorrect and a simple look at the Federal Reserve balance sheet makes the flattening of the yield curve quite logical.
Once the composition of the balance sheet is understood, it becomes quite clear that if the Federal Reserve continues on their QT path, the yield curve will continue to flatten, as it has been, and likely invest in several months. The question then becomes is the inversion of the yield curve the cause of a recession or symptom of a recession. In other words, if the Federal Reserve inverts the yield curve, as they are likely to do with the QT program, will that cause a recession in 2019?
As a stand-alone, 'yield curve inverting means recession', I would tend not to agree. The economic data is slowing materially, the growth in the money supply (M2) is contracting rapidly and bank loan growth is near 1% annually. All of these factors together, coupled with a potentially inverted yield curve in a few months, create a stronger argument for a recession in 2019. Nevertheless, let's take a look at the Federal Reserve Treasury holdings for an understanding of the recent flattening of the yield curve.
Below is a chart of the Federal Reserve Treasury holdings by maturity as a percentage of the total. As the chart shows, 45% of the Treasury bonds the Federal Reserve holds are in the 1-5 year maturity range. Just 26% of the bonds have a maturity greater than 10 years.
Government Treasury Holdings By Maturity:
Source: Federal Reserve, EPB Macro Research
When discussing the QT program, why would 10-year rates have a greater impact than 1-5 year rates when a majority of the selling is coming from the short end? Nearly 75% of the bond sales from the Federal Reserve will come with maturities 10 years or less.
More importantly, if 26% of the bonds have maturities 10 years or more, using a rough guess, only 5%-10% have maturities close to 30 years. Given this fact, using an assumption, 75% of the treasury sales will come with maturities less than 10 years and only about 5% will come with a 30-year maturity, of course, short-term rates will rise faster than long-term rates and flatten the yield curve. Also, there really should not be that much fear in regards to QT raising long-term rates since the majority of the asset sales is in the short duration space.
For evidence of this analysis and logical confirmation, the 30-2 spread, or the difference between the 30-year treasury rate and the 2-year treasury rate nearly hit a cycle low of only 88 basis points, down from 250 basis points in June of 2015.
All of the treasury curves I will show below have been contracting before the announcement of the QT program. I believe the contraction in the yield curve is two-fold. The yield curve has been contracting since 2015 as February 2015 was the peak in growth for this economic cycle and the yield curve tends to forecast growth. Also, the composition of the asset sales from the Federal Reserve has intensified the contraction in the yield curve across all durations starting in 2017, along with the announcement of QT.
30-2 Spread:
Source: YCharts, EPB Macro Research
The difference between the 30-year yield and the 5-year treasury yield moved down to just 49 basis points. It makes sense that the short-term rates would move higher at a faster pace than the 30-year yield given the skewed composition of the balance sheet and the asset sales.
30-5 Spread:
Source: YCharts, EPB Macro Research
The difference between the 30-year yield and the 10-year yield moved down to just 26 basis points and the spread can be seen contracting more severely starting in September of 2017.
30-10 Spread:
Source: YCharts, EPB Macro Research
The first yield curve inversion of this economic cycle has occurred (aside from t-bill inversions due to government shutdown risk). The spread between the 30 year breakeven inflation rate, and the 5-year breakeven rate inverted this week.
The breakeven rate is the market expectation of the average inflation rate over a given time period. The rate is derived from the treasury bond rate and the TIP (TIP) rate of equal maturity.
An inversion means the market is pricing in higher average inflation over the next 5 years than the average inflation rate over the next 30 years.
30-5 Breakeven Spread:
Source: ZH
The last time this curve inverted was during the 2008 recession. It is unusual that the market has higher short-term inflation expectations than long-term inflation expectations. The inversion and flattening of many yield differentials could be due simply to the composition of the asset sales of QT, but there are many other signs of growth slowing that indicate the flattening of the curves have more to due to QT.
The spreads in the corporate bond market are indicative of a growth slowing environment as well. The spread between investment grade bonds (LQD) and junk bonds (JNK) has been widening for over a year, bottoming in February of 2017, an indicator of slower growth expectations from the bond market.
Corporate Bond Spread Widening:
Source: YCharts, EPB Macro Research
Both a contraction in the yield curve and a widening of corporate bond spreads are market signals of lower growth expectations.
Bank loan growth over the past five years has dropped from a peak of almost 14% to 1.7% today. The trend in bank loan growth follows the yield curve to some degree as the yield curve is a proxy for loan profitability, 'borrow short - lend long'.
Bank Loan Growth:
Source: Federal Reserve, EPB Macro Research
Bank loan growth collapsing is another signal that there has been a real economic slowdown and the yield curve compression has more to do with growth than QT.
Lastly, the money supply growth (M2), one half of the Fisher equation of M2 Growth + Velocity Growth = nGDP growth, has dropped from nearly 8% down to 3.8%, in a similar fashion to the yield curve and bank loan growth.
Money Supply Growth:
Source: Federal Reserve, EPB Macro Research
It can only be surmised that given the composition of the Federal Reserve balance sheet, heavily skewed to the shorter duration, that the continuation of the QT program will have to flatten the yield curve further.
As the yield curve flattens further, bank loan growth will become less profitable and the drop from 15% to 1.7% may go lower or even into negative territory.
The reduction in bank lending and the money supply (M2) will result in lower economic growth.
The lower economic growth will keep a lid on longer-term rates (TLT), the rates least affected by QT asset sales and the most sensitive to economic conditions.
