The spread between 30-year and 5-year Government Bond Yields in the US fell to 0.32% this week, the narrowest gap since 2007. This means the US yield curve is very flat and there is a limited reward for investors to lend money to the US Treasury for the long-term; they would receive just an extra 0.3% per year if they wait a quarter of a century longer (in 2010 it would have been an extra 3% per year).
Such a flat yield curve raises the risk of yield curve inversion, when the yields on the long-dated debt are lower than on short-dated. Historically, this happens very rarely and has been a highly reliable indicator of economic recessions, with no false signals. In 2005-2006 it took about six months for the curve to invert from current levels. If the same pattern holds, the inversion point could be reached by year-end. Economic recession usually follows a few quarters after.
The Federal Reserve (The Fed) is going to be very sensitive to the shape of the yield curve when it makes up its mind about the pace of the monetary tightening cycle, and many of the Fed officials spoke on the subject this week. Federal Reserve Bank of St. Louis President James Bullard takes it seriously, saying that the prospects of a flattening curve should be debated “right now”. He believes rates should stay flat at least over the policy horizon, due to the lack of material inflationary pressures, and only rise if there are upside surprises. However, Bullard’s influence could be limited given he is a non-voting member of the Fed. John Williams, who takes the helm of the powerful Federal Reserve Bank of New York in June, agreed that a truly inverted curve, triggered by monetary policy tightening and the market losing confidence in the economic outlook, “is a powerful signal of recession”, but he is confident this is not happening now. He suggests that the current flattening is “a normal part of the process”, as the Fed raises rates, and continues to see three to four hikes this year. The futures market is pricing in another two moves from the Fed by the end of the year, while most economists are looking for three rate rises and the topic of a possible “policy error” is starting to gain traction.
If as a result of the Fed’s action the yield curve inverts, it would not be good news for the equity markets – the S&P 500 halved during the sell-offs, which started in 2000 and 2007. However, according to a J.P. Morgan analyst, it takes on average 10-11 months after the inversion point for the stocks to peak. And while markets are right to be nervous, the clock has not yet started ticking.