US Treasury bond yields could be signalling trouble ahead

After two Federal Reserve rate hikes in 2017 and a likely third one in December the US central bank might have expected that the bond market would have taken the hint and steepened the US yield curve. In normal circumstances, longer-dated yields might have been expected to have risen faster than the short-end. But that is not the case.

Instead, the US yield curve has been flattening and while the Fed might find the situation a little unnerving, it may have to come to terms with it.

After all, current circumstances aren’t normal but reflect attempts by the Fed, including moves to reduce the size of its balance sheet, to finally normalise monetary policy in the aftermath of the Global Financial Crisis and its aftershocks.

Higher yields in the longer end of the curve have not outpaced rises in shorter periods. Even as Stanley Fischer, speaking Friday on his last day as Fed vice-chair, said a December rate hike remains achievable if the economic data remains robust, the spread between the two-year and the benchmark 10-year US Treasury (UST) narrowed.

Admittedly, Friday’s UST yield moves are largely explained by benign US inflation data for September, which arguably lessened the case for a December hike, but concerns about the curve flattening had already been raised by Dallas Fed Reserve President Robert Kaplan on October 10.

Stating that he considered the low yield on 10-year USTs “a little ominous” Kaplan wondered if there was a risk that the US yield curve could become inverted, where short-end yields are above longer-end ones, a development which in the past has boded ill for the US economy.

“What I don’t want to see us do is raise rates so fast that we get an inverted yield curve because history has shown an inverted yield curve has tended to be a precursor to a recession,” Kaplan said.

Yet if the bond market takes the view that US inflation will remain lower for longer, then a rational actor might conclude that longer-end rates won’t rise too far too fast.

“From a market perspective, we’re (arguably) already there when it comes to pricing in lower trend US inflation,” wrote ING Bank last Thursday, noting that “even the Fed’s latest Primary Dealers survey [showed] that participants on average are looking for US inflation to average around 1.78 per cent over the next 10-years.”

“The lack of inflation premia suggests that bond yields are set to stay structurally lower for longer,” the Dutch bank concluded.

Another factor may also be contributing to a flattening of the US yield curve.

The Federal Reserve has effectively embarked on a policy of quantitative tightening through balance sheet reduction, no longer automatically rolling over holdings of USTs on maturity that had been previously purchased under successive programmes of quantitative easing.

The US Treasury will need to find alternative buyers.

There’s an argument therefore that if the Fed is going to be less of a buyer of USTs with a longer maturity, the US Treasury might have to pay higher yields for those periods to attract alternative buyers of US paper, helping to steepen the curve in the process.

But, as Steven Major, Global Head of Fixed Income Research at HSBC, argued earlier this month, the US Treasury is flexible, will respond to demand and that in current circumstances will likely therefore issue more short-dated paper. “At the margin, if there’s going to be an impact, it might make the curve a little flatter,” Major said.

Is it possible that the Fed which, in the words of its Chairwoman Janet Yellen, expects balance sheet reduction to “run quietly in the background,” may have misjudged the practical implications of its actions?

US-based Hoisington Investment Management thinks the effects of quantitative tightening “will have a profound slowing effect on money and credit” and that “therefore, the growth of [US] nominal GDP and inflation will be headed lower.”

It also argues that “continuation of quantitative tightening deep into 2018 would probably cause the yield curve to invert”. And that’s without the effect on the short-end of the yield curve of further potential US rate hikes in 2018.

The prospect of such an outcome would surely horrify the Fed but it cannot be ruled out. In the meantime a flatter US yield curve may help explain the buoyancy in equity markets, including in Asia, as capital seeks alternative investment plays.

The Fed might not like it but in the current environment, tighter US monetary policy seems compatible with a flatter US yield curve.

Kaplan’s concerns may be well-grounded.