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Is the flattening yield curve foreshadowing a US recession?

In the latest Ahead of the Curve, Silvia Dall’Angelo, Senior Economist at Hermes Investment Management, assesses the importance and implications of a flattening yield curve in the US.

The US treasury yield curve is a measure economists keep a close eye on. Historically, the curve has been a reliable indicator of future economic activity.

Most notably, every recession since World War II has been trailed by a curve inversion, i.e. instances where the spread between 10-year and 2-year yields turned negative. The curve has flattened in the last twelve months, with the spread between the yields narrowing to just 50bps in January. It is therefore possible that the spread could turn negative at some point this year. As such, it is unsurprising that market observers have become nervous about the possibility of a slowdown. But given the current environment of loose monetary policy, to what extent should we trust the US yield as a harbinger of a recession?

Chart: An inverted yield curve has correctly signalled an imminent recession in the past

Source: Reuters Datastream, Bureau of Economic Analysis, National Bureau of Economic Research (NBER) as at January 2018

Could the curve invert shortly?

The primary driver of a flatter curve in the first nine months of 2017 was long-term yields, declining despite the ongoing Fed’s hiking cycle. In the final quarter of 2017 they finally started to increase, but at a slower pace than short-term yields. The underperformance of long-term yields could be explained by either a belief the US economic cycle is mature, or term premium[1] compression due to ultra-accommodative central bank policy.

If the US economic cycle really is nearing its peak, it is easy to envision the treasury yield curve inverting in the near future. This scenario is a concern, as market expectations for the economy have at times been self-fulfilling.

However, if the depressed term premium is to blame for the flat curve, the informative value of the curve is poor, as it reflects the distortive effects of monetary policy on markets. This means macroeconomic risks are limited and the slope of the curve is likely to stabilise as central banks become less accommodative.

Heeding the lessons of history

Because the US treasury yield curve has been such a clear predictor in the past, it does seem sensible to pay heed to its indications. The flatness of the curve has caught the eye of the FOMC recently, although the committee is facing the same interpretative challenges discussed. In general, a flat curve in itself is not yet a concern for the Fed. However, were the curve to invert, this would capture more of the Fed’s attention. So far, the curve’s flatness has stood in isolation to other economic indicators. Should a yield curve inversion occur when inflation is still undershooting the official 2% target, the Fed would have a strong case to slow down or even pause its hiking cycle.

It is worth shifting focus to outside the US to put the recent US Treasury yield curve flattening into perspective. Curves in the UK, Eurozone and Japan all remain much steeper than in the US, likely reflecting earlier points in the business cycle. More interestingly, curves elsewhere have been far less predictive of recessions. This is particularly true in Japan, where unconventional monetary policy has been deployed since the 1990s, during which time the yield curve has never inverted.

Keeping a critical eye on the curve

In summary, there are a few reasons to doubt the US yield curve’s predictive power in the current circumstances. If the measure is merely reflecting the distortive influence of unconventional monetary policy, then the relevance of a possible inversion seems somewhat diluted. Conversely, as shown in Japan, a lack of yield curve inversion does not entirely negate the possibility of a recession.

Today it seems too early to worry about an imminent US recession. Not only is the spread between long-term and short-term yields still in positive territory, but macroeconomic data have been solid.

Nonetheless, signals from the yield curve cannot be ignored given their reliable track record, especially if accompanied by other weakening macro indicators. Should the curve invert – investors, policymakers and economists must pay attention.

[1] Long-term yields can be seen as the sum of expectations on the short-term rates and a term premium, i.e. the excess yield investors require to commit to holding a long-term bond.

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