The U.S. Treasury yield curve is flatter today than it was at the end of the Great Recession in 2009.  This week’s chart examines how flat the curve is now, and the potential for further flattening, possible inversion, or potential steepening. The 10s minus 2s steepness shown in the chart is the 2-year Treasury yield subtracted from the 10-year Treasury yield.

In general, a steep yield curve signifies a growing economy and a bullish market, as long-term bonds must provide greater yields to keep up with future growth. On the other hand, an inverted yield curve signifies a shrinking economy and a bearish market, as investors buy long-term bonds as safe havens, thereby driving their prices up and lowering their yields. As we can see from the chart, the yield curve inverted prior to the 2000 tech bubble burst and prior to the 2008 Great Recession.

With the Tax Cut now signed and underway, we would theoretically expect the yield curve to steepen as the market expects stronger economic growth. However, in the fourth quarter of 2017 — as the legislation gained momentum through Congress and was ultimately signed into law by Trump — the yield curve flattened instead. This is a possible sign that much of the tax stimulus may have already been priced into assets.

Previous Fed Chairs Greenspan and Bernanke both said the economy would be fine after the yield curve inverted in 2000 and 2008, respectively. Going forward, we may expect that the new Fed Chair Jerome Powell will be more cautious in preventing inversion.

Prospects for curve steepening still exist, as inflation — which rose recently — may continue to rise as the economy benefits from the Tax Cut. Rising inflation would then be expected to raise the long end of the yield curve. However, we continue to see the mitigating effect of overseas reach for yield, as U.S. rates across the curve still outyield rates from the rest of the developed markets. Non-U.S. pensions, insurers, and banks continuing to buy long U.S. bonds may drive up prices and keep yields low on that segment of the curve.

Given the flat yield curve, we recommend maintaining an allocation to core bonds for yield, diversification, and principal protection, as well as the inherent moderate duration position.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

 

As America’s central bank, the Federal Reserve is tasked with the important power of keeping our nation’s employment and inflation within a range that is conducive to prosperity. The Fed does this by controlling interest rates. By keeping interest rates low, the Fed enables businesses to borrow more easily, thereby increasing employment, but at the risk of raising inflation to levels that could be too high. In Fed-speak, the Fed is being dovish when it keeps rates low to stimulate the economy — stepping on the gas versus pumping the brakes. On the other hand, if the Fed raises interest rates, it is harder for businesses to borrow, thereby containing inflation, but at the risk of raising unemployment. In this case, the Fed is hawkish when it raises rates to rein in the economy — pumping the brakes.

This week’s chart looks at the dovishness or hawkishness of the Federal Open Market Committee, the committee within the Federal Reserve that sets interest rates. The committee is going through much change: Jerome Powell — a dove — was recently nominated by Trump to Fed Chair starting in 2018 and was affirmed by the Senate. Janet Yellen — a dove — will be stepping down as Fed Chair at the end of this year. Randal Quarles — a centrist — recently joined the committee.

The Fed publishes the committee’s membership for each of the next three years. By assessing the recent speeches and papers from each member, we constructed a Dove-O-Meter to show how dovish or hawkish the group is expected to be. It is important to note that the Fed board of governors, which comprises a large portion of the Federal Open Market Committee, will have four empty seats out of seven total once Yellen steps down, so there may be some change to the dovishness or hawkishness of the group as Trump continues to nominate more people. However, with the members that we know will be on the committee, we can expect a relatively centrist Fed in 2018 and a relatively dovish Fed in 2019 and 2020, as shown in the chart. A centrist Fed in 2018 may be more balanced in normalizing rates and its balance sheet, while a dovish Fed in 2019 and 2020 may lean towards hiking rates less and trimming its balance sheet less to continue to be more stimulative.

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The U.S. Treasury yield curve, as measured by the difference between 10-year Treasuries and 2-year Treasuries, has flattened significantly over the past several years, decreasing from 2.65% on December 31, 2013 to 0.65% on November 15, 2017. In fact, this is the flattest that the yield curve has been since November 4, 2007, just prior to the onset of the “Great Recession,” and this has sparked concerns about a potential recession on the near-term horizon. A flattening yield curve has typically been associated with concerns about future economic growth, so mounting worries about a potential recession are understandable.

However, these concerns appear to be a bit premature. First, it is important to note that every recession since 1980 (including the “Great Recession”) was precipitated not only by a flattening yield curve, but by an inverted yield curve, meaning that yields on longer-term (i.e. 10-year) Treasuries were below yields on shorter-term (i.e. 2-year) Treasuries. Given that yields on 10-year Treasuries are currently 0.65% higher than yields on 2-year Treasuries, we are nowhere near an inverted yield curve. Second, it is worth noting that it is fairly common for the yield curve to flatten during rate hike cycles when short-term rates tend to rise faster than long-term rates. Given that the Federal Reserve Bank has increased interest rates four times since 2015, a flattening yield curve is not an unexpected occurrence. Finally, it is important to note that the yields on U.S. Treasuries — particularly the longer-end of the curve — have been significantly impacted by the actions of other central banks around the world. In 2013, the Bank of Japan launched a $1.4 trillion quantitative easing program that primarily focused on purchasing longer maturity Japanese government bonds. In 2015 the European Central Bank launched a $1.2 trillion quantitative easing program that primarily focused on purchasing longer maturity European government bonds. These large-scale bond purchase programs drastically lowered interest rates on Japanese and European government bonds, enticing investors from around the world to purchase U.S. Treasuries, which offered significantly higher relative yields. Between December 31, 2013 (when the spread between 10-year and 2-year Treasuries was 2.65%) and November 15, 2017 (when the spread between 10-year and 2-year Treasuries was 0.65%), yields on 10-year U.S. Treasuries actually decreased from 3.03% to 2.34%, while yields on 2-year U.S. Treasuries increased from 0.38% to 1.69%.

While the flattening yield curve is somewhat concerning, it appears that this combination of Federal Reserve rate hikes boosting the short end of the curve and quantitative easing programs from global central banks depressing the longer end of the curve is the primary driver of the flattening yield curve, not concerns about future economic growth in the United States.

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The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.