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Interest rate debate: US yield curve leveling off

The flattening of the US yield curve has been the subject of a significant debate because, in the past, curve inversions have been associated with economic slowdowns. This article discusses the reasons for the flattening and a forecast for economic growth in the US.

Trends in the US yield curve

Since the beginning of 2017, the US yield curve has flattened significantly. The spread between 10-year and 2-year Treasury yields has declined from above 135 basis points to only 30 basis points. Also, the spread between 30-year and 10-year yields is down to a mere 15 basis points. Historically, flattening yield curves have been associated with economic slowdowns and inversions with recessions. It is therefore no surprise that the above development has triggered a vigorous debate.

Reasons why the yield curve is leveling off

One side suggests that US monetary policy is already almost too tight, with bond markets on their way to pricing in an economic slowdown. However, the real federal funds rate, one of the most important key interest rates in the US, is at least 100 basis points below most estimates of its equilibrium. In addition, significant positive growth drivers, such as US fiscal policy stimulus, rising capex and continued credit expansion, will offset the much-discussed growth risks, at least in the near term.

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The real federal funds rate is at least 100 basis points below most estimates of its equilibrium.

Bonds showing low risk premiums

The alternative explanation for the flatter curve is that the bond risk, or term, premium is being depressed by special factors: First by persistently strong demand for government bonds, due to large and still-expanding central bank balance sheets, the banking system’s continued need for high-quality assets, and a general savings glut. Second by proactive and credible Federal Reserve policy, which has lowered the inflation risk premium. If this is true, we could see the global economic expansion continue as the yield curve flattens further or even fully inverts.

US economy possibly cooling off

In reality, however, policymakers are very likely to take the additional information into account, especially if the curve does invert, that is, if short-term bonds earn more than long-term instruments. The Federal Reserve may thus well slow, or temporarily halt, its rate-hiking cycle in 2019 to avoid signaling to the market that monetary policy is becoming too restrictive. As a result of a slower Federal Reserve hiking path, the risk of a US slowdown would diminish, but the inflation risk premium could rise, leading to a renewed steepening of the curve.

Steepening of yield curve conceivable

Yet, this is not the only reason to prefer a short duration stance in most major currencies. If global trade tensions were to escalate, yield curves could begin to steepen as well because markets would anticipate that central banks might delay monetary tightening measures to not disrupt growth further and accept some inflation build-up in return. Additionally, bond markets are not priced for central banks lagging behind inflation, a scenario that is not so far off given that US consumer price inflation is currently running above 2 percent both in headline and core inflation numbers.