The US yield curve continues to flatten. Yesterday, the gap between yields on US two-year and those on 10-year government bonds narrowed to just 30 basis points, the slimmest margin since August 2007.
A flattening yield curve traditionally has been seen as a negative sign for markets: a proxy for restrictive monetary policy, slower bank lending, and weak longer-term growth prospects. But in our view it is more important for investors to watch Fed policy, credit creation, and growth data itself, than the yield curve. On this count, we do not yet see cause for significant concern:
- A flattening yield curve is not a good predictor of recessions. An inverted yield curve, where short-term rates rise above long-term rates, is a better one, but even then lacks useful predictive power. Since 1988, an inverted two-year/10-year yield curve has preceded the start of US recessions by as few as 150 and as many as 750 days. There is also reason to believe it is becoming an even less useful indicator today, with institutional demand for long-term assets unrelated to the short-term business cycle, suppressing term premia.
- The yield curve may not invert. At present we expect the Fed to continue to tighten and the curve to flatten further, reaching 10bps over a six-month horizon. But Fed officials have already noted that trade tensions are starting to impact business sentiment regarding investment and hiring decisions. If trade tensions were to move more towards reality than rhetoric, the Fed might conceivably slow the pace of tightening, which could mitigate the flattening trend.
- Policy is not yet restrictive, credit conditions are still supportive, and growth is good. Last week Minneapolis Fed President Neel Kashkari said the Fed is still one or two hikes away from the likely level of neutral rates, where policy is neither restrictive nor accommodative. The Chicago Fed National Financial Conditions Index, currently -0.8, continues to show that financial conditions are loose. The ISM manufacturing index rose to a higher-than-expected 60.2 in June, up from 58.7 in May.
We are overweight equities but remain watchful of economic data, and hold counter-cyclical positions in US Treasuries and equity put options.
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