Investors continue to ignore the flattening of the curve and the risk that comes with it. Experts and members of the Fed for the influence that the asset purchase program (QE) has had on the yields of long-term bonds. However, history shows that the Fed has been wrong on several occasions when interpreting an interest rate curve that does not usually fail as a predictor of recessions.
This means that the yield on short-maturity bonds (one-year or two-year bills or bonds) is approaching the 10-year bond yield, while the inversion of the curve occurs when short-term interest rates term are higher than long term. This feature is rare and has occurred at a few times over the last few decades, always coinciding with a period of short-term rate hikes by the Fed, as is currently the case.
Under normal conditions, the yield curve has a positive slope. The explanation is logical: it is not the same to lend money to someone for three months or a year than to do it with a promise of repayment of ten or twenty years. Debt or bonds with longer maturities usually offer higher interest (term premium), because a longer period of time is synonymous with greater uncertainty.
The yield curve in the US has gone from presenting a differential (spread) of almost 300 basis points between the two-year Treasury bond and the ten-year one to the 23 points at which it currently moves. This flattening has turned up in recent months. From the Fed they have downplayed this movement. Jerome Powell himself, president of the agency, replied that “there are no reasons to think that the probability of a recession in the next two years is high” after being asked about the drop in the spread between bonds.
The Fed’s ‘mistakes’
This was not the first time that a member of the Federal Reserve downplayed this issue. The economists at Guggenheim Partners recall in a note that in February 1989 (17 months before the recession) Gerald Corrigan, president of the New York Fed, commented that “the yield curve, both in the US and elsewhere, does not it was a reliable indicator of future inflation… And if it hasn’t been a reliable indicator of future inflation, and most recessions have been inflation-induced, I’m not prepared to bet the mortgage on curve signals. of types”.
Peter R. Fisher, head of the Federal Open Market Committee, commented in March 2000 (10 months before the recession) that “the change in forecasts in the supply of Treasury bonds has introduced a significant amount of noise in the curve of types”.
In February 2007 (10 months before the recession), Ben Bernanke, former Fed Chairman, argued that “falling term premiums and perhaps big savings by chasing a limited number of investment opportunities around the world have led to a flattening or even permanent inversion of the yield curve, and that pattern does not necessarily predict a slowdown in the economy or recession.”
All these ‘mistakes’ by relevant members of the Fed call into question the message of calm that Jerome Powell or John Williams, governor of the New York Fed, are issuing today.
The crisis will come in 2020
Despite robust third-quarter economic growth, investment firm Guggenheim Partners’ stance is that . Strategists who have described this scenario include global chief investment officer Scott Minerd. Strategists maintain that the yield curve is a powerful signal.
“Although there is little risk of a slowdown in the short term, a more restrictive monetary policy will overcome an overheated economy,” they point out in the document. “Despite the prevailing view to the contrary, the flattening of the yield curve remains a powerful indicator of a looming recession.”
David Page and Gregory Venizelos, strategists at Axa, say that they see the flattening of the curve as a relevant sign “even if the causes that are causing it are different this time. These economists believe that a flat curve influences credit and bank profitability, which in turn affects the economy: “This headwind for growth, together with the fading of fiscal stimuli, is likely to leave the US economy down.”
The prominent argument that QE has caused the curve to be too flat has several flaws. For example, they do not take into account that net Treasury issues have increased in recent years or that various central banks have sold US Treasury bonds to keep their exchange rates against the dollar afloat. These two factors have been able to offset the power of QE in reducing interest rates on long-term bonds and, therefore, flattening the curve.
The yield on the benchmark 10-year Treasury note is up about 70 basis points to 3.10% this year, while the 2-year equivalent is up 95 basis points to 2.83%. The difference between the two narrowed to an 11-year low of 19 basis points on August 24 before rebounding to near 27 basis points on Tuesday.
For Guggenheim, the data on economic activity and future consumer confidence corroborate the signal of a flattened yield curve. For example, the difference between current consumer confidence and expectations for the future shows that respondents think current conditions are at an all-time high.
“As the cycle ages, consumers begin to see the present more favorable than the future. These falling expectations are coinciding with the flattening of the curve” commented the aforementioned economists. According to the model used by these experts, it is possible that the current expansion will have about 18 months left.
All of this suggests that the next crisis will arrive in 2020, as several institutions have predicted throughout this year.
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