Yield Curve Flattening to Pause
The rapid flattening of the US yield curve, which saw the gap between two-year and 10-year Treasury yields fall to just 24 basis points recently, is likely now to pause for some respite.
This significant flattening came about as the Fed signalled its determination to push through policy normalisation, with four hikes now expected for the calendar year 2018, which would take the upper bound of the Fed Funds rate to 2.5% by year-end. With the dot plots signalling another four hikes in 2019, it’s easy to see the yield curve inverting in the next 12 months. The gap between two-year rates and Fed Funds is currently 66bp, and has been comfortably at 50bp or more for some time as markets have realised the Fed really is going to deliver on its projections. Should this short part of the curve maintain its steepness, then by year-end, with Fed Funds at 2.5%, we could have an inverted curve with two-year rates above 3% and 10-year yields still below 3%.
It seems somewhat premature to be talking about an inverted curve while we are in the midst of another highly impressive earnings season, and tomorrow quarterly US GDP is likely to see its high print of this cycle. So why has the curve become so flat?
There have been two forces at work. The front end has been consistently rising with each rate hike, while the long end has rallied, with 10-year rates falling from their 3.12% high in May down to between 2.80% and 2.90%, where they have spent most of last month or so. These two opposing forces caused the massive flattening of the curve.
In the last few days, however, 10-year yields have broken out of this range and are pushing back up to 3% and along with that, the 2s/10s curve is back up to 30bp.
The long end has had a constant drip feed of bad market news over the last three months, and this has put long dated Treasuries back in fashion. A heady mix of trade war worries, EM woes from Turkey, Argentina and Brazil, and political uncertainty in Europe, has spooked markets. The Fed though remains resolute and is looking through all of this, signalling a resilient ongoing recovery, improvement in labour markets and a gradual, but not worrying pick-up in inflation. So in short, the Fed sees no problems, but the markets do – the perfect combination for a 2s/10s flattening.
However, the drip feed of bad news is now abating as it is slowly overwhelmed by positive fundamentals at the company level, and good news at the macro level will likely join in tomorrow with the expected cycle high print in US GDP. US President Donald Trump and European Commission President Jean-Claude Juncker reached an accord on US/EU tariffs overnight, Italian politicians will soon be off to the beach, and the EM negative news feels well priced in.
Consequently we think longer rates have the scope to go higher over the summer and the yield curve will get a reprieve, at least temporarily. As always there could be ‘new news’, but the fundamentals seem ready to take their turn in charge of sentiment.
