Is the flatter US yield curve cause for concern?

For the first time in a decade, the 2-year/10-year US Treasury yield spread has narrowed to less than 60 basis points (bps). The flattening has led to some investor concern since yield curves inverted, with the 2-year yield rising above the 10-year yield, prior to each of the past three US recessions.

Technical factors, rather than fundamentals, explain a lot of the flattening.

But while a flatter curve can indicate investor pessimism about the growth outlook, we do not believe this flattening is cause for investor concern at this stage:

• Technical factors, rather than fundamentals, explain a lot of the flattening. First, quantitative easing programs have pushed 10-year term premiums into negative territory. We estimate the term premium was 1% ten years ago; today it is –0.45%. The term premium is the compensation that investors require to hold a long-term bond instead of a series of shorter-term bonds. Historically, this has been positive as investors want additional yield to tie up their money for longer. Second, with corporate tax cuts on the agenda, US corporates are pre-funding their pension liabilities to take advantage of the 35% tax deduction, increasing the demand for long-dated Treasury strips. And third, breaking from a policy in place since 2009, the Treasury will stop attempting to lengthen the maturity of the government’s debt. This could limit upward pressure on long-term interest rates from government issuance.
• Structural changes that have held down long-term rates so far are likely to persist. Slower productivity and an aging population have reduced the neutral real interest rate, while inflation expectations have also been well-anchored close to the Fed’s 2% target. Meanwhile, at the short end of the curve, the Fed is raising rates, but only in response to strength in the economy, not high inflation. US GDP has just posted back-to-back quarters of 3% growth.
• It isn't unusual for short- and long-term yields to move independently. In the 2004–06 hiking cycle, long-term rates fell from 7.3% to a low of 5.5% at the start of 2006. But yields then rose again to 6.75%, as tightening continued into June 2006. In the 1988–89 cycle, short-term rates were hiked by 325bps, but 10-year yields rose just 75bps, and were back where they started by the time rates were cut in June 1989. And in 1994–95, a 300bps increase in fed funds corresponded to a maximum rise in 10-year yields of just over 100bps. Yet once again, rates were back where they started when the Fed eased in July 1995.

Overall, we believe the flattening in the yield curve reflects a combination of technical and structural factors holding down long rates in conjunction with expectations of gradual Fed tightening, and not investor fears of a downturn. We see the whole yield curve shifting modestly higher, but also flattening slightly further. Our 12-month forecasts for 2- and 10-year yields are 2% and 2.5% respectively. We don’t expect this to prevent equities from grinding higher, and remain overweight global equities.

Bottom line

A flattening US yield curve, as short-term rates rise and long-term rates remain static, has raised concerns that it’s a precursor to a downturn. But we believe low long-term rates can be explained by a combination of structural and technical factors, while rising short-term rates reflect expectations for gradual Fed tightening amid good short-term growth. We stay overweight global equities.

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