The US Treasury yield curve has resumed its flattening from last Fall. This is a negative signal for future growth. Curve flattening primarily signals a risk of the Fed overtightening and triggering recession going forward. Let me flesh out some more thoughts below.
The initial Fall 2017 flattening
Let’s go back to November. I wrote a post “Why the flattening yield curve doesn’t worry me yet” because there was a lot of commentary about imminent recession. I wrote that “I would sooner expect economic acceleration.” And, yes, we did get acceleration. Flattening came to an end and the market moved to worrying about Fed rate hikes.
But the case for recession wasn’t ever really there.
the yield curve has to invert to signal recession. Every time there has been a recession there has been an inversion beforehand. And because long-term interest rates are a series of future short-term rates, what an inverted yield curve is essentially saying is that on balance Treasury market participants believe that the Fed will be forced by a weakening economy to start cutting rates in the medium-term future in order to prevent the economy from becoming even worse. That’s why December 1994 was a near miss and June 1998 saw a brief inversion but no recession. In the case of 1994, the Fed was forced to cut and the economy actually recovered. In 1998, the Fed also cut and added liquidity to boot, even helping engineer a rescue of LTCM. The economy avoided recession again.
Curve flattening isn’t recession, inversion is
We were some 50 basis points away from curve inversion. And, remember, curve inversion is a signal of future recession, something like 12 to 18 months out, not of an imminent one. So not only was the flattening curve not a sign of recession, even if the curve had inverted, it would need to stay inverted. The Fed would need to ignore the signal. And then we would need to wait another year before recession actually occurred. Monetary policy acts with a lag. And the restrictive credit conditions of an inverted curve need time to work their way through an economy.
Later in November, I also wrote that:”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.” And by that, I meant that if the Fed tried to hike once in December 2017 and three more times in 2018, the curve would resume its flattening. And eventually we would see inversion aka overtightening. That’s how recessions happen.
My thoughts on renewed flattening
As I wrote last night, my timetable was for economic weakness to appear later. The weak data this early into the synchronized global growth phase has surprised me. But the fact that the Treasury curve has resumed flattening makes sense. The data call for it.
A string of poor data has stalled the march higher to 3% on the 10-year. Even assuming the weak data represent a pause in the synchronized growth acceleration, they make it harder to achieve 3% before the curve flattening from overtightening begins. In fact, I think the present flattening may just be the beginning of overtightening that I thought would happen late Spring.
The path to totally flat by mid-year
I am still expecting a pancake flat – 25 basis points at most – curve by mid-year. Between now and then, we will need to see how the data shake out and whether the Fed is data dependent. Right now, the 2-year is up 2 basis points to 2.27% from when I wrote last night’s post-market piece. And the 10-year is at 2.81% up only 1 basis point. That’s another point of flattening.
I’ll get worried when we break below 50 basis points between the 2- and the 10-year. Right now, we are headed in that direction.