By John Plassard, senior investment specialist at Mirabaud Group
While the United States is now set to see a rate cut in September, we are also witnessing a flattening of the yield curve. Some economists believe that this is a sign of an imminent recession or evidence of an error in monetary policy. What are we to think?
The facts
When analysing the economy, we look at several indicators: PMIs, inflation and employment. But the spread (or slope of the curve) between short- and long-term bond yields is also crucial. When the yield curve “inverts” – when the yield on a five-year bond, for example, is higher than that on a 30-year bond – it makes news.
Historically, such an inversion is followed by a recession, although this is not an absolute truth, as we have seen recently.
The prospect of lower long-term rates arises when the economy slows down and investors start looking for other places to put their money, perhaps because they don’t expect the stock market to perform well. They then turn to the higher yields offered by long-term bonds. The increase in demand leads to a rise in the price of long-term bonds, which lowers their yields (yields move inversely to the price of the underlying bond).
The latest movement on the yield curve was fuelled by comments made by Fed Chair Jerome Powell at the Jackson Hole symposium, which boosted bets that the Fed would cut rates at its next meeting.
The curve has flattened and should give us a strong signal, but what is it?
Definition of a flattening of the yield curve
In the chart above, you’ll notice that the curve starts to flatten sharply towards the end. The underlying concept of a flattening yield curve is simple: the yield curve flattens – that is, it becomes less curved – when the difference between short-term bond yields and long-term bond yields decreases.
There are many ways to interpret this figure.
Firstly, a flattening yield curve may indicate that expectations of future inflation are falling. Normally, investors demand higher long-term rates to compensate for the loss of purchasing power, as inflation reduces the future value of an investment. Conversely, this premium decreases when inflation is less of a concern.
A flattening of the yield curve can also occur in anticipation of a slowdown in economic growth. Sometimes the curve flattens when short-term rates rise in anticipation of an interest rate hike by the Federal Reserve. This is clearly not the case today.
Sometimes the yield curve flattens to such an extent that it inverts, with short rates becoming higher than long rates. This is particularly the case when a central bank decides to curb inflation by raising its key rates to such an extent that it could inhibit growth.
This restrictive monetary policy leads to a rise in the cost of credit for banks, a fall in the money supply in circulation and, ultimately, a slowdown in activity over the medium term. An inverted curve is therefore a leading indicator of the economic situation.
Why is the curve flattening?
The flattening of the yield curve occurs when the spread between short- and long-term interest rates narrows. This phenomenon can be attributed to a number of factors, often reflecting market expectations about the future economic environment.
- Anticipation of slower economic growth: When investors expect the economy to slow, they anticipate that the Federal Reserve will cut interest rates to stimulate growth. This expectation causes long-term bond yields to fall, as investors buy them in anticipation of a rate cut, while short-term yields may remain higher if the Fed has not yet started cutting rates.
- Inflation expectations: If inflation is expected to fall, long-term bonds become more attractive, as the purchasing power of future interest payments is less likely to be eroded by inflation. This increased demand pushes down long-term yields, contributing to the flattening of the yield curve.
- Monetary policy measures: When the Federal Reserve raises rates to fight inflation or cool an overheating economy, short-term yields rise. If long-term rates do not rise proportionately, this is due to expectations of an economic slowdown, and the yield curve flattens.
- Flight to safety: In times of economic uncertainty or geopolitical risk, investors often seek the safety of long-term government bonds, which are considered low risk. This increased demand for long-term bonds lowers their yields, resulting in a flatter yield curve.
- Global economic conditions: Economic conditions in other countries can also influence the yield curve. For example, if global growth slows or if central banks in other major economies cut rates, demand for long-term US bonds could increase, reducing their yield relative to short-term bonds.
- Market liquidity and risk appetite: A change in investors’ risk appetite can also cause a flattening. If investors switch from riskier assets to safer, long-term government bonds, their returns fall, resulting in a flatter curve.
- Quantitative easing (QE): Large-scale purchases of long-term bonds by central banks (as in quantitative easing programmes) can lower long-term yields directly by increasing demand, thereby flattening the yield curve.
In short, the yield curve flattens when long-term interest rates fall or short-term rates rise, generally reflecting expectations of slower future growth and/or lower inflation expectations.
Does a flattening yield curve herald a recession?
When the yield curve starts to flatten out, looking more like a pancake than an upward ski slope, bond market participants begin to worry. The fear is that the shape of the curve will reverse, with long-term yields becoming lower than short-term yields.
Why is this important? Because it could be the sign of a recession. An inverted curve indicates that there are fears that people will lose their jobs or that businesses will close. Against this backdrop, investors demand higher returns from companies to compensate for the increased risk to their
short-term repayment capacity.
Short-term yields can also rise relative to long-term yields if the Fed is in a rate hike cycle, trying to slow the economy by making money harder to borrow. Rate rises have more of an impact on the short end of the curve, generally causing short yields to rise more than long yields.
Today, however, we are not in this scenario. We are not in a situation where short-term yields are rising faster than long-term yields, but where short-term yields are about to fall faster than long-term yields. There is a difference.
However, some economists still claim that the flattening of the yield curve could be a psychological marker, meaning that investors are losing confidence in the market’s growth potential…
What happened during the last few crises?
The Fed has embarked on quantitative easing (QE) over the last two interest rate cycles. The first was in response to the global financial crisis and the second in response to COVID-19.
As short-term interest rates on Treasuries approached zero, the Fed continued to stimulate the economy by lowering yields on the long end of the curve, creating a flatter curve.
The acceleration of quantitative easing and strong demand for Treasury bonds from foreign markets and pension funds have contributed to a fall in long-term yields.
In early 2022, in the wake of poorly anticipated inflation, uncertainty over the extent of the Federal Reserve’s monetary policy tightening had the effect of flattening the curve, this time as a result of short yields rising faster than long yields. The result was a rapid narrowing of spreads between 2-year and 10-year Treasury bonds.
The situation is still “normal”!
The current flattening of the US yield curve has more to do with technical factors than fundamentals.
It is therefore important not to overreact. With the data-dependent nature of political decisions, the potential for contradictory interpretations of new economic data is high (for example, we saw a contraction between the worsening employment situation in the US, but an increase in retail sales).
Add to this the market’s complacency about the cycle of falling rates, and you have a perfect recipe for volatility.
The situation in Europe is different … for now
Logically, this flattening of the yield curve is different in Europe (and particularly in Germany) and reflects the difference in the monetary cycle between the 2 sides of the Atlantic. There has even been a steepening of the curve.
If the yield curve steepens, this means that the spread between long and short-term interest rates widens. In other words, long-term bond yields rise faster than short-term bond yields, where short-term bond yields fall while long-term bond yields rise. As a result, the price of long-term bonds will
fall relative to short-term bonds.
When the yield curve is steep, banks are able to borrow money at lower interest rates (because they are borrowing short-term) and lend at higher interest rates.
It is interesting to note here that a steepening curve generally indicates stronger economic activity and higher inflation expectations, and hence higher long-term rates. This is not yet the case, but we can imagine that the pressure on the ECB’s shoulders is increasing.
Note, however, that the situation can be reversed very quickly…
How can I follow the theme on the stock market?
Most bond investors have an interest in maintaining a stable, long-term approach based on diversification objectives rather than technical issues such as the evolution of the yield curve.
But short-term investors can potentially benefit from yield curve movements by keeping an eye on certain exchange-traded products, such as:
- LYXOR US CURVE STEEP 2-10 (STPU LN)
- ISHARES 20+ YEAR (TLT US)
These two types of products are a good way of observing the yield curve. You can also buy a “flattener” via a derivative where you buy the long end and sell the short end.
Conclusion
The flattening of the yield curve can send out several signals, not least that of a recession. While we believe that this movement is due more to technical factors, it is important not to play it down.
