Thanksgiving macro market update: Yield curve flattening edition

The treasury yield curve continues to flatten as long-term yields lag the rise in short-term rates.  

• Whereas short rates move in anticipation of the Fed's expected policy path, long rates continue to price in subdued inflation and nominal GDP growth.
• Since the Fed began tapering their third installment of quantitative easing, the 2-10 spread has collapsed by roughly 200 bps from 2.57% to .58%.
• In contrast, during 
• QE 1 the yield curve steepened from 1.36% to 2.82% (December 2008 - March 2010),
• QE 2 from 2.32% to 2.73% (November 2010 - June 2011), and
• QE 3 from 1.42% to 2.6% (September 2012 - December 2013).

Looking at these trends during shifts in monetary accommodation, it strongly suggests that Fed policy is driving the shape of the yield curve via the short end.  In other words, as one should expect expansionary monetary policy has coincided with a yield curve steepening while a less accommodative stance has in part caused the curve to flatten.

Importantly, a benign view as to why the US 10-year yield refuses to convincingly move higher along with their short-term counterparts is that global bond investors have been starved for yield as both the ECB and BOJ continue to expand their balance sheets.  Essentially, the ECB and BOJ asset purchase programs have reduced the stock of fixed income instruments available to the private sector.  In order for global fixed income investors to meet their return objectives, they have been forced to either accept greater duration and/or credit risk.  This in turn has the effect of driving yields and credit spreads lower particularly in the Eurozone and Japan but also globally as well.* 

However, this point of view isn't entirely convincing when it comes to longer dated risk-free treasury securities seeing as their yields decline in periods of risk-off.  Moreover, the revival of synchronized global growth that commenced in 2016 coincided with a low in treasury yields.  Thus, if anything ECB and BOJ asset purchase programs along with a Fed that at the time was reluctant to hike rates enabled the long end of the treasury curve to rebound.  After a reprieve, the 2-10 spread resumed its descent only after the Fed restarted the rate tightening cycle in December 2016.

Regardless, given that major central banks outside of the US have aided in a global growth rebound after the China scare at the start of 2016, the US yield curve flattening can be safely ignored for now.  This is particularly the case since past curve inversions have preceded US growth slowdowns.  The curve is simply not there yet.**

The ECB embarked on their version of QE on January 22, 2015.

Since 2016, the US dollar correction has been cause and consequence of a global growth rebound.  

Due to the US dollar's preeminent role in the global financial system given the degree of dollar denominated leverage as well as exchange rate pegs tied to it, the USD serves as a great proxy for global risk appetite.  Unsurprisingly the two downtrends in the greenback at the beginning of both 2016 and 2017 have coincided with EM outperformance.

USD EM Bond Fund ETF outperforming 7-10 year Treasury Bond Fund

Until the dollar weakness definitively reverses (September 2017 bottom must hold), gains in emerging markets should prove durable heading into 2018.  Thus, the yield curve flattening shouldn't be an immediate concern absent a return of a strong dollar.  Should the dollar strengthen materially alongside declining long-term treasury yields, market participants would then be reminded of past risk-off environments.  Up to this point, the dollar's weakness has served as a crucial tailwind for the rest of the world and US multinationals that has worked to offset the Fed's less accommodative stance.

As mentioned in prior posts, the USD continues to trade with interest rate differentials.  A revival in global growth that began in 2016 has coincided with a bottom in both JGB and German Bund yields.  The latter two would likely need to decline for the dollar to sustainably rebound.

Financial market conditions are still favorable for now.

• The US and global equity markets have not yet shown signs of topping and are still in a strong upswing.
• Year-over-year US equity returns have confirmed the rebound in US GDP growth since 2016 (albeit it still weak by historical comparisons).
• Junk bond yields and spreads are both only signaling caution.  Spreads have yet to widen substantially as junk bond prices appear to have only recently begun a potential topping process.  
• Although equity market index valuations are stretched, major equity price trends are still strong.

Could crude be the wildcard?

Although it still remains to be seen whether oil will break above $60 resistance, should crude do so one would presume that the Fed would have every reason to proceed with the current pace of rate hikes***.  Problematically, much like the past cycle, the Fed's reaction to the possibility of climbing oil could push the yield curve to invert sometime in 2018/2019.

• Between February 1999 and August 2000, crude bottomed at $12.31 before reaching $33 as the 2-10 spread declined from .16 to -.45%.
• From July 2003 to November 2006, oil roughly doubled in price ($30 to $63).  Conversely, in this period the 2-10 spread contract to a cycle low of -.16% after hitting a cyclical high of 2.69%.  

In the months that followed each oil and yield curve divergence, the Fed was forced to cut rates ahead of the last two recessions.  For the most part, the post GFC cycle has witnessed crude and the yield curve trading in tandem.  However, a divergence is starting to appear.  This should not be ignored unless oil fails to recapture $60

During her latest (perhaps last) testimony before Congress, Yellen reiterated the following,

Sen. Mike Lee, a Republican from Utah, asks Yellen about a Joint Committee on Taxation statement that predicted the Fed would respond to the Republican tax plan with aggressive rate hikes. 

Yellen doesn’t address the issue directly but said the Fed is not scared of strong growth per se. 

“The Fed is not trying to stifle growth,” Yellen said. “We are worried about trends that could push inflation above our 2% objective.”

Despite having undershot their 2% target for much of the post-GFC period, Fed leaders still appear far more concerned with the possibility that inflation could potentially move above 2% than they are with the actual ongoing weak inflation readings.  Seeing as this mentality of treating 2% as a ceiling rather than a target is unlikely to change under a Jerome Powell led Fed, rising oil prices would almost certainly result in hikes that all but ensure a yield curve inversion sometime in the next 12-18 months.  Ironically by preemptively raising policy rates to stave off the specter of unwelcome above trend inflation, the Fed has capped their ability to react to price pressures as they now risk inverting the yield curve by doing so.  Absent a much steeper curve, they simply do not have the room to continue hiking without jeopardizing the current expansion.  Time will tell whether they will repeat some of the policy errors committed in the buildup of the Great Recession.

Summary:

• The yield curve has flattened considerably since the Fed starting tapering QE3 in December 2013.  The expect path for Fed policy has caused the short end to increase relative to more subdued yields on longer dated treasuries.
• In part, the ECB and BOJ balance sheet expansions have reignited a global "search for yield" that has narrowed credit spreads following the 2016 China induced risk-off environment.
• The return of risk seeking behavior saw a correction in the USD which has reinforced the global growth dynamic as seen in the strong performance in emerging markets.
• Risk assets are still very much in an ongoing upswing.  US high yield has only recently shown signs that caution may be warranted.
• After trading in sequence with one another during much of the post-GFC cycle, crude oil and the 2-10 spread have moved in opposite directions since June/July 2017.
• If this divergence were to continue with crude above $60+, a yield curve inversion becomes very likely within the next 12-18 months.  Yields on long end of the curve could even breakout to the upside but not enough to offset more rapidly rising short rates.  It goes without saying that inversion would not bode well for risk assets down the line.  This is something to consider but not necessarily in the immediate future.  For now and as always, the trend is your friend.

*This is a variation of the global savings glut hypothesis popularized by Ben Bernanke where desired savings is chronically in excess of desired investment.  The insatiable demand for real and financial assets as well as stores of value has outpaced the inclination for economies as a whole to issue enough securities.  To compensate, market participants are left to bid up asset values which very well could account for elevated bond prices, stretched equity valuations, as well as the bitcoin mania.  Although necessary, asset purchases by price insensitive major central banks have arguably exacerbated this phenomenon. 

**From peak to trough, the 2-10 spread has drifted upwards since the 1980.  It perhaps suggests that the curve may only need to flatten without venturing below zero for a recession warning to sound.  This is still rather speculative but worth contemplating.

• The February 1980 reading hit a low of -2.01%.  The June 1985 peak reached 1.58%.
• -.43% in March 1989 to 2.57% in September 1992
• -.47% on March 2000 to 2.69% in July 2003
• -.16% in November 2006 to 2.84% on January 2011

***A Trump tax reform that does not improve RGDP trend growth would also give the Fed plenty of cover to act more aggressively.