The 2-year/10-year US Treasury yield spread closed at 58 basis points (bps) on 21 November, the first time it has dropped below 60bps in a decade, the gap having narrowed by more than half this year. A flattening yield curve typically indicates investors expect future growth to weaken. And the fact that the Federal Reserve is raising short-term rates, while 10-year yields remain virtually unchanged since the first hike, is seen by many as a “conundrum.”
But we believe neither is the case and there is no cause for alarm:
- Structural changes are depressing long-term rates. Given slower productivity and population growth, US trend growth and hence the neutral real interest rate are structurally lower than before.
- At the other end of the curve, the Fed is raising rates, but in response to strength in the economy, not high inflation. US GDP has just posted back-to-back quarters of 3% growth.
- During the 2004-06 US rate hiking cycle, long-term rates fell, which Fed chairman Alan Greenspan called a conundrum. Contrary to Greenspan's comments, short-term and long-term yields move independently quite frequently. In the late 1980s the Fed increased rates by nearly 300bps and 10-year yields remained flat. During the 1994-5 tightening cycle long-term yields fell.
So we believe the flatter yield curve reflects expectations of gradual Fed tightening, not a downturn. We see the whole yield curve shifting higher, but also flattening slightly further, as structural factors keep long-end rates low. We do not expect this to prevent equities from grinding higher, and we remain overweight global equities.
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