If the Yield Curve Could Talk

The Dynamic Yield Curve

For those who may have a life beyond the daily activities in the bond market, it is possible to have missed the dramatic changes in the Treasury yield curve over the last four years. Short-term yields have risen sharply while long-term rates have fallen, with the 7-year segment of the curve as the pivot point for the shift. Chart 1 below illustrates the dramatic change in the curve structure from the end of 2013 to the end of 2017. During this time, the slope of the Treasury curve flattened 212 bps between the 2-year and 10-year maturities, from a steep slope of +264 bps in late-2013 to a relatively flat +52 bps at the end of 2017. The yield spread between 2s and 10s at the start of this year was one-half the long-term average spread of approximately +100 bps since the late-1970s.

As many investors know, the yield curve has been one of the more reliable leading indicators of economic growth and inflation over many cycles. A flattening curve has often been a signal of slower growth ahead. More worrisome has been an inverted curve, where short-term rates are higher than long-term, which has preceded every post-World War II recession. The curve’s predictive value, however, is not perfect, with occasional false positive signals for both flat and steep curves. The steep 2013 curve was, in fact, a false signal of faster growth and higher inflation. Instead, the curve was reflecting the Fed’s extended zero-rate policy which held short-term rates historically low. Since then, the Fed’s financial repression has mostly ended as the Fed normalizes monetary policy.

The curve may once again be sending misleading signals as we do not yet see signs of economic warning clouds on the horizon. Rather, growth has strengthened; averaging nearly 3% in the final three quarters of 2017, and the cyclical momentum has extended into 2018. In addition, the corporate and individual tax cuts should provide a modest boost to growth this year. More importantly, this fiscal stimulus may help extend the length of this cycle. January was the 103rd month in this economic expansion and surpassing the record 120-month expansion of the 1990s now seems a possibility, if not a high probability.

A growing economy has provided support for the Fed’s five gradual one-quarter point rate hikes since December 2015. The market currently expects three rate hikes this year which, if correct, would push the target federal funds rate to the 2.0% - 2.25% range, a level many economists believe is the “neutral” rate given the slower expected growth rate for the U.S. economy going forward. Neutral is defined as the point at which monetary policy neither slows nor enhances the pace of growth and presumably further rate adjustments would occur only to tamp down persistent inflation above the Fed’s 2% target. While 2-year Treasury yields should continue to rise as the federal funds rate rises, the Fed may not do so at the same one-for-one pace as in 2017, given the approaching neutral rate “ceiling.”

Further out the curve, the decline in long-term yields has been due to a combination of favorable fundamental and technical factors. Relatively slow growth and moderate inflation plus strong demand from natural, long-maturity buyers, such as life insurers and pensions de-risking, have contributed to the lower yield trend. Abundant global liquidity and a nearly insatiable demand for income from retiring baby boomers have been supportive as well. Although no single indicator is infallible, including the yield curve, experienced investors know to keep an eye on the shape of the yield curve when considering their outlook.