No, the Treasury curve isn’t flattening because the ECB and BoJ are ‘printing money’

My model of interest rates and currencies says that long-term yields are just an amalgam of future short-term yields with a term premium tacked on. There’s nothing in there about money flow and people moving money to where yields are highest. I think this matters when thinking about what the flattening yield curve signals as central banks begin to tighten globally.

The reason I mention this is that I have heard some chatter that goes a bit like this: “It used to be that flattening yield curves were a sign of bad things to come in the real economy. But in today’s central bank-manipulated world, you can’t really know if that’s true. On the one hand, we have the Fed jacking up rates. On the other hand, we’ve still got the ECB and the Bank of Japan printing money and driving down yields. Just maybe, the flat yield curve reflects Fed hikes at the short end but liquidity preferences for dollar assets on the long end.”

I don’t buy this. Here’s why. My model goes exactly like this:

To explain the behavior of longer-term rates, it helps to decompose the yield on any particular bond, such as a Treasury bond issued by the US government, into three components: expected inflation, expectations about the future path of real short-term interest rates, and a term premium. At present, all three components are helping to keep longer-term interest rates low. Inflation is low and expected to remain so, so lenders are not demanding higher returns to compensate for anticipated losses in their purchasing power. Short-term interest rates are also expected to remain low, as bondholders appear pessimistic about growth prospects and the sustainable returns to capital in coming years. When short-term rates are expected to remain low, longer-term rates tend to get bid down as well.

That was Ben Bernanke in 2015, when short-term rates were expected to stay low. Now that they are going up because of Fed rate increases, you can change Bernanke’s last two sentences to read, “Short-term interest rates are no longer expected to remain low because the Fed has begun to normalize policy by increasing interest rates, as growth prospects have increased. When short-term rates are expected to increase, longer-term rates tend to get bid up as well, unless bondholders appear pessimistic about medium-to-longer-term growth prospects, in which case the yield curve flattens.”

Notice there’s nothing there about the ECB or the BoJ in any of that. Why? Because the currency is the release valve. Treasury yields have nothing to do with foreign demand. If demand for American assets falls, it would be reflected in the currency. Treasury rates remain a combination of expected inflation, expectations of future real short-term rates and a term premium. That’s it.

Bottom line: every time you hear a ‘flow of funds’ argument to describe why fundamental factors in an asset market are changing, you should be extremely sceptical. Treasury rates change based on inflation and Fed policy — with a term premium tacked on. It has nothing to do with the ECB or the Bank of Japan. So if the yield curve is flattening, it is doing so, for domestic economy reasons, not because foreigners are demanding US assets.

I am not concerned about future growth quite yet. Nevertheless, since a flattening yield curve is synonymous with tightening cycles, I am almost ready to hit the panic button! I will be concerned if the curve flattens into the 40-50 basis point range. There’s no way the Fed can hike 4 times through the end of 2018 without risking the curve inverting. And that would be a really bad market signal. In fact, if the curve stayed inverted, it would signal recession.