Is Flatter Yield Curve Predicting A Recession Beginning In The United States, Or In The Emerging Market Nations?

Summary

The yield curve continues to flatten out, signaling to many that a recession might be on the way.

Given current statistics, it seems hard to believe that the recession will start out in the United States.

However, emerging market nations are having their difficulties, and with relatively strong economic growth in the US and a stronger US dollar on the horizon, problems could start there.

Longer-term yields are dropping, when they are supposed to be increasing. What seems to be happening?

The yield on the 10-year note closed at 2.892 percent on Tuesday afternoon.

On May 17 this year, the yield was at 3.106 percent. This was a time when the longer-term yields were at new (recent) highs and, supposedly, were heading higher.

The components of the yield at that time were as follows: the yield on the 10-year Treasury Inflation Protected securities (TIPs) was at a near-term high of 0.929 percent and expected inflation was at 2.177 percent.

At the close on Tuesday, the components broke out this way: the yield on the 10-year TIPs was 0.708 percent and expected inflation was 2.121 percent.

The inflationary expectations built into the yield dropped by roughly 6 basis points, and this drop has taken place as it appeared as if inflation were back in the game.

On Friday, the Commerce Department announced that the core rate of consumer price inflation came in showing a 2.0 percent year-over-year rate. This is right on the Fed’s target and it is something that had not been achieved for a long time.

The consumer prices index, without food and energy prices, came in with a 2.3 percent year-over-year rate of increase, but this measure had crossed the 2.0 percent line earlier.

Certainly with the core rate of inflation moving up to meet the Fed’s target, one might think that inflationary expectations might, if anything, rise. But, no….

The more important fact to me, however, is the fact that the yield on TIPs dropped by about 22 basis points. As I have described over the past year and one half, I believe that there are two possible reasons for this decline.

First, economic growth is slowing down. But, the opposite seems to be the case. The initial guesses for second quarter growth are pretty robust and the economy seems poised to turn in a pretty good 2018. So, this doesn’t seem to be the answer.

The other argument I have given for the falling TIPs yield is that over the past month and one half, the United States has again been the beneficiary of risk averse monies flowing in from around the world. The specific reason for this movement of funds is the difficulty that emerging markets are having because of the recent strength of the US dollar.

Since the middle of April 2018, the U.S. Trade-weighted Dollar Index: Broad has moved from 117.30 to 124.12, an increase of almost 6.0 percent. The currencies of the emerging nations have declined relative to the U.S. dollar and the stock markets of these countries have dropped significantly.

The money has flown from many of these countries into the market for U.S. Treasury securities as a safe haven for the time being. This has not been an unusual movement over the past six or seven years.

Consequently, the yield on the 10-year TIPs is lower than it might have been. And, this downward movement in rates, particularly since the middle of May, had been a great surprise to many of us.

The ironic thing that has happened because of this unexpected movement is that the U.S. Treasury yield curve is flatter than what anyone might have expected it to be.

Over the past week, the yield curve became flatter four of the five days the markets were open.

Right now, there are only 30 basis points between the yield on the 10-year Treasury note and the yield on the 2-year. In the middle of May, the difference was close to 55 basis points.

This is quite a drop.

Now, for the future. Almost everyone would agree that by the end of the year, the Federal Reserve will has raised its target rate of interest two more times. That would raise the upper limit of the target range 50 basis points, up to 2.50 percent.

If the yield on the 2-year Treasury note increases by 50 basis points, this maturity would have a market yield in excess of 3.00 percent, which, of course, is higher than the yield on the 10-year note right now.

Three more Fed increases in 2019 and the upper limit of the target range will rest at 3.25 percent.

And, if the Federal Reserve, being data driven, feels that rising inflation may be a real threat, then, as Fed chairman Jerome Powell has warned, the short-rate could be even higher than that.

So, what about the yield on the 10-year note? Will it rise further in 2018 and 2019 as was expected earlier this year?

If I am correct about the international flows of money into the “safe haven” of United States financial markets, one must see this flow stopping…and even reversing…if longer-term interest rates are to show much of a rise.

But, many are predicting a slowing in the world economy coupled with a continued strengthening of the U.S. dollar in the currency markets as the growth rate of the U.S. economy remains above 2.5 percent. This is not the picture that emerging market nations want. Given this scenario, there is a strong chance that there will still be risk-averse monies looking for safe havens.

Given this scenario, it seems that the yield on the 10-year Treasury note will not go too much higher, even if core inflation picks up a little more in the United States.

Will we get a flatter yield curve but with no apparent U.S. recession in sight?

Given such a scenario, where might the economic problems come from?

Well, the economic problems could come from the emerging market nations. Their problems are arising from extended use of debt to the extent that if their currencies are falling and world interest rates are rising, their debt loads could become unbearable. Argentina has already sought monies from the IMF. And, there are four or five other countries that have massive debt loads that could also be seeking bailout funds in the future.

So, the failure of yields on longer-term bonds to rise point to an out-of-equilibrium market condition. The thing we need to watch for is how the out-of-equilibrium situation is resolved.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.