The US yield curve compressed to its flattest level in a decade on 2 November. Two-year Treasury yields remain below 10-year Treasury yields, but the gap fell to 74 basis points, its lowest since November 2007. A flattening yield curve is generally considered a sign that investors are expecting future growth to be subdued.
But there are reasons why we don’t think the flattening curve indicates growth concerns:
- With the Fed gradually tightening policy while structural, regulatory and demographic pressures on long-term yields remain, a flatter curve should be considered natural.
- There is no evidence that a flatter curve is affecting bank lending – a key transmission mechanism into the real economy. US financial conditions are at their loosest since 1994, based on the Chicago Fed National Financial Conditions Index, which currently stands at -0.91.
- Historically, it is only inverted yield curves that have been a good predictor of economic downturns. The seven recessions over the last 50 years were preceded by the Fed hiking rates enough to invert the 3-month-10-year yield curve. At about 1.18% currently, this yield curve is far from inverting.
So we believe the flatter yield curve reflects expectations of gradual Fed tightening rather than downbeat growth expectations. We believe both the US and the global economy can withstand a gradual withdrawal of accommodative policy, and remain overweight global equities. We expect the yield curve to flatten further - our 12-month forecasts for two-year and 10-year yields are 2% and 2.5% respectively.
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