Editor's Note: Below is a brief excerpt from Market Edges, a weekly market newsletter contextualizing key economic data within big picture macro trends.
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"If one does take history at face value though, the $14.3 trillion Treasuries market is sending a warning about the economic outlook. Yield curves are the flattest in a decade, and it’s no coincidence that about 10 years ago marked the start of an 18-month recession. The yield curve has proven a reliable indicator of impending economic slumps when it inverts, and short rates exceed longer-term yields." -Bloomberg (11/13/17) |
The yield spread (10-year Treasury yield minus 2-year Treasury yield) is currently at a lowly +72bps. It's common for U.S. growth bears to say a flattening yield curve is indicative of a slowing U.S. economy, since bonds catch a bid in the flight to safety during a slowdown. But bears are missing two important points about bond yields: Inflation and global central bank policy divergences.
1. INFLATION
What’s happening here is the short-end of the curve (2-year Treasury) is up 36 basis points, to 1.654%, in just the past three months as consumer prices heat up and investors demand a higher return in excess of inflation (more on that in our Chart of the Week, “An Update on Our Inflation Call”).
2. CENTRAL BANK DIVERGENCES
Meanwhile, the policy divergence between the Fed, which is getting more hawkish, and the still easing central planners at the BoJ and ECB has forced investors to buy Treasuries on any meaningful pullback in domestic bonds. That's put downward pressure on U.S. Treasuries. Still, 10-year yields are higher compared to their foreign counterparts.
You can see this in the spread between the 10-year Treasury yield and the average of Japanese and German 10-year yield. As U.S. growth bottomed in 2016, the spread between U.S. and JGB/German 10-year yields was around 1.6%. As speculation of Fed rate hikes has increased on U.S. #GrowthAccelerating that spread is now 2.2%.
