The yield curve has now flattened into the danger zone

Quick post here. I caught a tweet by Bloomberg’s Lisa Abramowicz this morning noting that the yield curve was at its flattest since the Great Financial Crisis. Looking at the data, I noted that the 10-year bond is trading at only 49 basis points more than the 2-year bond. That is under the 50 basis point threshold I set out in November.

Curve flattening from unresponsive back end

All of the action has been at the front of the curve where the Fed has the most control.

US Treasury curve flattening


For me, it is worrying that the flattening is all ‘front-ended’. It says we are back to Greenspan’s conundrum. Then-Fed chairman Alan Greenspan mused aloud on the Fed’s inability to get long-dated Treasuries to react to the Fed’s rate hike train. Eventually the curve inverted and we went into a recession.

And though Fed officials like Cleveland Fed President Mester are poo-pooing the yield curve as a market signal of weakness, I think there is something there. Here’s what I said in November:

Given that the long end of the curve has not responded to economic growth or to Fed hikes, I believe four hikes in 2018 would take us into the danger zone of a spread of just 40-50 basis points or less. The potential for recession would start to rise dramatically at that point were the Fed to hike into a curve that flat.

No recession until late 2019 or in 2020 at the earliest

Remember, my timetable is flattening precedes inversion and inversion precedes recession. Inversion gives the Fed 12-18 months to react — or for past policy to feed through. That puts us late into 2019 for policy to feed through.

The Atlanta Fed’s GDPNow figure is pegging Q1 at about 1.8%. This may be cyclical since Q4 GDP was just upgraded to 2.9%. But I think Q2 numbers will be key in determining this. If Q1 is weak and nowcasts for Q2 are also weak, but the Fed still decides to move to four rate hikes, I would expect the curve to flatten even more.

What we’re seeing is a Fed that is concerned about overheating. And to the degree that the economy slows, their tightening bias may cause them to miss those signs of slowing. n fact because some Fed officials are actively dismissing the yield curve as a signal, I am sure they would miss any signals of slowing.

So I continue to expect the curve to flatten into the 25 basis point realm by mid-year. Again, you need to question the secular bond bear market thesis. The data are moving the other way now.

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