Eric C. Jussaume, Senior Vice President and Portfolio Manager, 617-441-1494
Does a Flattening Yield Curve Signal a Slowing Economy?
The steepness of the yield curve is measured by the yield differential between short-term and long-term U.S. Government bonds. The yield curve typically has a positive slope in a healthy economy. The Federal Open Market Committee (FOMC ) controls the direction of short rates via policy moves, and long rates are more reflective of economic growth and inflation expectations.
A flattening yield curve is typically associated with a tightening in monetary policy by the Federal Reserve Bank. However, in the current market, short-term rates are moving higher while long-term rates have been relatively stationary. This type of flattening, particularly when the 2/10’s spread (the spread difference between the 2-year and the 10-year Treasury Bonds) persists below 70 basis points (0.70%), can signal slowing long-term growth expectations that have historically been associated with a rising risk of recession. As of December 6th, the spread has flattened to approximately 50 basis points.
In order to understand why the yield curve has flattened so dramatically since the end of 2013, it is important to understand the history of the current market cycle. During the market crisis in 2008, the Fed began a series of stimulus and liquidity-providing programs, including Quantitative Easing (QE) and Operation Twist to revive the economy; purchasing close to $4 trillion of government bonds, including mortgages.
At the beginning of 2015, as the economy continued to improve, the Fed indicated it would begin the process of interest rate normalization, and and has hiked rates four times since. The Fed is expected to increase rates again in December 2017 and two to four times in 2018. Short-term rates are moving higher, but long-term rates have not moved much. Growth has been relatively strong with third- quarter U.S. GDP growth at an annualized rate of 3% and an unemployment rate of 4.1%.
If the economy is growing and near full employment, why are long-term rates not rising? Multiple factors and market forces combine to keep mid- and longer-term bond yields compressed:
- With almost $8 trillion of global debt trading at negative yields, foreign investors are purchasing U.S. securities for their more attractive higher yields.
- Record inflows into fixed-income ETFs and mutual funds reflect investors’ asset allocation preference for the relative safety of fixed-income.
- Wage growth remains low and the Fed’s preferred measure of inflation, Personal Consumption Expenditures (PCE), is 1.32%, well below their 2% target. Additionally, the market’s forward inflation expectations are still below the 2% Fed inflation target. Perhaps the Fed ought to shift policy to price-level targeting or make its willingness to overshoot the inflation goal known.
- Over the longer term, the aging of the U.S. population is likely to result in less risk-taking and increased demand for bonds.
The Cambridge Trust Conclusion
As the yield curve flattens, there is less incentive to invest in longer maturities as comparable yields can be achieved in shorter-term securities. However, as the yields on longer-term securities fall, the corresponding prices rise and therefore positive total return is still being generated. In this time of uncertainty with regard to the growth/inflation outlook, future Fed policy and global market mood, our fixed income portfolios are duration-neutral with an overweight to corporate bonds. Corporate profits have increased and corporations have strong balance sheets.
In 2017, we increased the credit quality of the Cambridge Trust Company bond portfolios and would look to reduce our credit exposure in 2018 if the economy were to deteriorate, as the flattening yield curve might be foreshadowing. Given the current solid economic and corporate fundamentals, however, we are comfortable with our portfolio positioning. Considering the amount of manipulation that central bankers have done to yield curves in recent years, the flatter U.S. yield curve is not as readily comparable to previous history. Far more concerning, and far more trustworthy as a recession indicator, would be if the yield curve were to invert to a negative slope. If that scenario were to occur, we would look to increase our exposure to shorter-term government securities.