The predictive powers of the yield curve | Calamatta Cuschieri

The spread between long-term and short-term government borrowing rates in major advanced economies has narrowed significantly since mid-October.  In the US, this gap has narrowed by over 50 basis points over the past three months, resulting in a so-called flattening of the yield curve which shows the interest rates that buyers of government debt demand in order to lend their money over various time periods.

Given that lending to governments in major advanced economies is considered a safe bet, these borrowing rates are mostly influenced by investors’ assessment of the prospects for economic growth and inflation, and how those in turn will affect central bank interest rates.  The US yield curve in particular, thanks to the central position of the dollar in the global financial system, acts as a kind of barometer of the market’s view about the future path of the world’s largest economy.

The yield curve is normally upward sloping, whereby a higher fixed rate of return is earned from lending money for longer periods of time.  Shorter-term yields tend to represent what investors believe will happen to central bank policies in the near future.  Longer-dated maturities represent investors’ best guess at where inflation, growth and interest rates are headed over the medium to long term.  Thus, when an economy is slowing, and inflation expectations decline, yields on 10-year and 30-year bonds typically gravitate towards those of shorter maturities as bond buyers bet there is less need for central banks to raise borrowing costs in the future.

This so-called flattening in the yield curve may at some point become a recessionary signal, in particular if it becomes downward-slopping or inverted.  In fact, an inversion of the yield has preceded every US recession for the past half a century.  On the contrary, during periods of economic expansion and accommodative monetary policy, where governments use low interest rates to encourage spending and boost economic activity, the yield curve tends to steepen.  This occurred following the 2008-09 financial crisis and most recently last year, when investors positioned for a surge in growth and inflation as the economy reopened after the pandemic.

The attitude of the Federal Reserve in 2021 was initially focused on being more tolerant of inflation than in the past which effectively helped to drive this steepening.  By keeping rates low in the short term, the central bank allowed inflationary pressures to build, possibly leading to sharper rate increases ahead.

Since then, the shape of the curve has been volatile.  First, in late spring, longer-dated bond yields fell as investors came to the view that longer-term growth might tail off sooner than expected, meaning less monetary tightening would be required.  At the same time, markets largely believed the Fed’s mantra that inflation would be mostly transitory in nature.

The curve then started a renewed bout of steeping in late summer, with the market anticipating that the US central bank would announce a so-called “tapering”, or scaling back, of its monthly $120 billion bond purchases, mainly of bonds with longer-term maturities.  This was eventually followed by a renewed wave of flattening in late September which was driven by the persistence of high inflation, which surprised many market participants.

Since then, markets have begun betting that the Fed will have to raise rates faster in the short term, pushing short-dated yields higher.  At the same time, longer-dated bond yields have fallen, particularly after the emergence of the Omicron coronavirus variant has cast a shadow over the economic recovery.  Consequently, the gap between the 10-year and two-year US yields tightened in late December to its narrowest point in about a year.

To some investors, this latest flattening is a sign that the Fed will only raise rates by a small amount, given relatively modest growth prospects in the medium- to long-term.  Others go further, arguing it is a sign that aggressive rate rises would be a policy mistake, that would choke off economic growth and therefore leave the central bank needing to cut rates again.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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