Investors split on meaning of key bond market barometer for economy
THE yield gap between short and long-term Treasurys has shrunk to its narrowest level since 2007, the year the financial crisis gathered steam. But few investors and economists are worried that a repeat of the 2008 meltdown is in store.
While analysts have long considered the gap, known as the yield curve, a key barometer for the health of the economy, many are split about what the signal means now. Much of their disagreement is rooted in the exceptional conditions of the past decade: emergency measures from global central banks that have produced little inflation, unemployment falling with few signs of wage pressure and stock markets that continue to climb with little volatility.
The uncertainty is accentuated by the contrast in economic conditions from the last time the yield curve was similarly compressed. In 2006 and 2007, as short term rates matched and even exceeded long-term rates, a phenomenon known as an inverted yield curve, there were clear signs that the economy was overheating. Housing prices, which had been surging for several years, were seen as unsustainably high, securitised products had spread risk throughout the financial system and stock prices were supported by a wave of aggressive leveraged buyouts.
Today’s flattening comes even as the economy seems to be humming along, sending an unclear signal at a time when stocks keep pushing to fresh records in a rally propelled by signs of synchronised global growth, and fuelled recently by hopes that US tax cuts can provide a further boost.
Some investors today support the traditional view that the narrowing gap is a signal that excessive policy tightening by the Federal Reserve risks pushing the economy into a recession.
“The markets are pushing back against the Fed,” says Michael Collins, a senior portfolio manager with PGIM Fixed Income, which has placed trades that will profit if the gap shrinks. If the central bank continues to raise interest rates, “the yield curve is going to get flat, stocks are going to sell off and the economy’s going to get hit,” he says.
But with few signs of a slowdown, others speculate that the forces at work are unlike other times. Just as the Fed’s expansion of its bond portfolio to US$4.2 trillion has failed to spur inflation, monetary policies intended to boost consumer prices in Europe and Japan may be holding down US interest rates. Central bank rates are below zero there are fuelling demand for relatively high-yielding US government debt, holding down the benchmark 10-year Treasury yield when it might otherwise be rising to reflect solid growth prospects in the US.
“We are in a global synchronised recovery – everybody knows that,” says Brian Jacobsen, head of multi-sector strategy at Wells Fargo Asset Management. “What everybody’s worried about is how long can this last. As it gets longer in the tooth, people are going to worry more and more.”
The lack of inflation pressures, particularly on hourly wages, has befuddled policy makers who have been expecting the lowest unemployment rates since the dot-com boom to force employers to lift salaries. The Fed has raised rates three times since December 2016, and is forecasting four more increases through 2018, citing its forecasts that inflation will soon perk up. Yet inflation, using the Fed’s preferred measure, has persisted below its 2% target.
There is additional uncertainty from Washington, as some of the curve’s widening at the beginning of 2017 came from expectations that President Trump would be able to pass plans to boost infrastructure spending and cut corporate and personal taxes. That led to a surge in expectations for faster growth and higher inflation, which lifted 10-year Treasury yields to 2.609%, the highest since 2014.
“As it became apparent none of these things were happening, you’ve seen the curve flatten,” says Ilya Gofshteyn, a macro strategist at Standard Chartered Bank.
The yield curve Wednesday narrowed to about 0.59 percentage point from 1.25 percentage points at the start of the year, near the narrowest gap since November 2007. Most of that change has been from a climb in two-year Treasury yields, which tend to rise on expectations of interest-rate increases from the Fed. The 10-year Treasury yield, which typically reflects expectations for growth and inflation, has fallen to 2.322% from 2.446% at the end of 2016. Yields rise when bond prices fall.
The yield curve’s pinch has been especially apparent in bank stocks. The KBW Nasdaq Bank Index of large US commercial lenders has slipped roughly 2.2% this month as the S&P 500 has gained around 0.8%. A steepening yield curve tends to boost banks’ lending profitability, since they can borrow at low short-term rates while lending at higher long-term rates.
While the factors influencing the yield curve also may be particular to this moment, some investors say the warning should still be heeded. Following five of the last six periods where two-year Treasury yields rose above their 10-year counterparts, the economy tipped into recession within a year, according to data from the St Louis Fed.
Many investors in the Treasury market, such as Steve Bartolini, a portfolio manager at T. Rowe Price, are betting that the gap will continue to narrow. One reason is that the Fed officials appear “willing to accept inflation below their target” as they continue to raise rates, he said. The 10-year yield tends to peak near the Fed’s benchmark when it has finished raising rates. Bartolini expects that to be at 2.25-2.50%. – In parnership with THE WALL STREET JOURNAL