US yield curve flattening: nothing to see here

The flattening of the US yield curve has inspired much commentary and hand-wringing in certain quarters lately. The concern is overdone.

Looking back at periods of rising US policy rates over the past 30 years, history would suggest there is nothing remarkable about today’s level of long-dated bond yields relative to those of shorter maturities. The chart below shows the gap between the yield on ten-year and two-year US Treasuries:

Longer-dated government bonds have, more often than not, tended to offer higher yields than short-dated bonds, which means the yield curve typically slopes upwards. That is, until the market senses that interest rate policy is ‘tight’ and starts to forecast reductions in the central bank’s policy rate, at which point the curve inverts; an inverted curve being a popular signal of recession around the corner.

In recent months, the slope of the US yield curve has flattened. The reason this has caused confusion is that it has occurred at a time when US economic growth has been robust:  the US has just registered 6 months of 3% annualised GDP growth. And so, with the yield curve still positive but at its flattest for 10 years, there are suggestions that the bond market is signalling cause for concern.

Historical perspective

Looking back over 30 years, however, recent yield curve behaviour appears entirely ‘normal’. During periods when the Fed Funds rate is rising, the yield curve flattens so long as inflation expectations and duration risk premia remain under control, which has largely been the case over the comparison period (and very much remains so today).

This time around, we observe the same behaviour: since early 2014, when the bond market gradually began to anticipate the first interest rate hike (as shown by the implied one year rate in one year’s time in the chart below), the curve has flattened appreciably as the Fed increased rates from 0.25% to 1.25%.

Taking the difference between 2yr and 10yr bond yields, the slope of the curve currently is 70bps. Nearly two years and 100bps into a tightening cycle, this looks unremarkable. It is roughly where the slope was in early 2005 and mid-1988, although flatter than in 1994 when the Fed implemented a rapid hiking cycle of +300bps over 12 months. Today’s curve is slightly steeper than the level which persisted through the second half of the 1990s, a period when US real GDP growth averaged an exceptional 4.2%.

It is, therefore, far from obvious that the current slope of the US yield curve represents something to be worried about from a macroeconomic perspective. Strong growth, low inflation and a modestly positive yield curve slope is not abnormal. If the Fed continues on its path of gradual increases in the Fed Funds rate, it would be logical to anticipate a further flattening of the curve, although even this tells us little about how far longer term yields will rise in tandem (if they do so at all).

Rather than its slope, the anomaly compared to recent decades is the low level of US yields across all maturities, a feature of the post-GFC environment, and especially since late 2011. Looking ahead, much depends on whether the Federal Reserve – and the bond market – believe the post-crisis regime of low real interest rates persists, or whether a return to an environment which begins to resemble the ‘old normal’ lies ahead…or, indeed, something entirely different again.