SEVERAL UNUSUAL FACTORS ARE CONTRIBUTING TO THE FLATTENING YIELD CURVE -- LOW INFLATION IS HELPING KEEP BOND YIELDS DOWN -- SO IS THE FACT THAT FOREIGN BOND YIELDS ARE MUCH LOWER THAN TREASURIES
YIELD CURVE FALLS TO LOWEST LEVEL IN A DECADE ... I've been reading a lot about the yield curve falling to the lowest level since 2007 and the potential warning that carries. The green bars in Chart 1 plot the spread between 10-year and 2-year Treasury yields (the yield curve). After peaking at the end of 2013, it has since fallen to the lowest level in a decade. The flattening yield curve is often a warning of a slowing economy and a potential stock market peak. The real danger signal, however, occurs when the yield curve "inverts". That happens when the two-year yield rises above the ten-year. The last two times that happened was in 2000 and 2007 (see red circles). The two black arrows show peaks in the S&P 500 following shortly thereafter which led to recessions in both instances. The good news is that the yield curve isn't that close to inverting. The point of this message is to suggest that some unusual factors may be distorting the yield curve. If that's true, then it may not be carrying as much of a warning as it did in the past.
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Chart 1
CRUDE OIL SPIKES PLAYED A ROLE IN PAST PEAKS... The green line in Chart 2 plots the 10-year Treasury yield, while the red line plots the two-year yield. The last two inverted yield curves in 2000 and 2007 followed big rises in the short-term yield (red circles). That was due mainly to the Fed raising short-term rates to slow the rise in inflation owing to spikes in the price of oil (gray area). The price of crude tripled during 1999 (from $10 to $34) which caused the Fed to tighten. From 2003 through 2007, crude quadrupled in price (from $25 to $100) which caused the Fed to tighten even more. [Crude finally peaked at $150 in mid 2008 during the financial crisis]. Both oil spikes contributed to inverted yield curves. In both instances, the ten-year yield also rose. The red box area to the bottom right, however, shows the short-term rate starting to rise during 2014 and reaching the highest level in nine years. But the longer term yield (green line) has actually declined over the past three years. That suggests that the falling yield curve over the last three years may have less to do with rising short-term rates, and more to do with falling or flat long-term yields. And that has everything to do with the introduction of quantitative easing around the world which has kept long-term bond yields artifically low. [Note: Current yields are still well below those reached in 2000 (6%) and 2007 (5%). And the price of oil is much lower as well].
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Chart 2
FED QE PUSHED TREASURY YIELDS LOWER... The Fed announced the start of quantitative easing (QE1) in November 2008 in the midst of the financial crisis. QE2 was launched in November 2010, while QE3 started in September 2012 (see red arrows). Not surprisingly, Treasury yields fell during those five years. Treasury yields spiked during 2013 in the so-called "taper tantum" as the Fed hinted at an end to QE. It finally did end QE in October 2014. Bond yields, however, continued to drop until 2016 and have stayed relatively flat since then. Part of the reason for that decline was the plunge in the price of crude oil (gray area) and other commodities during 2014 and 2015. But another reason why Treasury yields have stayed so low was the introduction of quantitative easing in foreign countries which pushed foreign bond yields even lower than in the states.
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Chart 3
FOREIGN BOND YIELDS ARE WEIGHING ON TREASURIES... Chart 4 compares the 10-Year Treasury yield (green bars) to similar maturities in the UK (red line), Germany (blue line), and Japan (orange line). The UK launched its version of QE in March 2009. Japan started its QE program in April 2013. The ECB started QE near the start of 2015 (shortly after the Fed ended its QE program in October 2014). Up until the second half of 2013, Treasury yields traded close to the same levels as European bond yields. During 2014, however, German bond yields fell much more sharply than those in the U.S. and UK. Yields in the UK plunged during 2016 after the Brexit vote and have traded much lower than the U.S. since then. Weaker bond yields in Europe (and Japan) since 2014 have acted as a weight on Treasury yields. And that helps explains why Treasury yields have stayed so low since then. Lower foreign bond yields increase the demand for higher-yielding Treasuries which holds Treasury yields down. And that's helping cause the yield curve to flatten. It could be argued that the flattening yield curve in the states has more to do with quantitative easing in foreign markets than any signs of weakness in the U.S. economy. Which also suggests that the flattening yield curve may not carry the same meaning that it did in the past. We won't know for sure until central bankers get out of the way and let global bond yields normalize and seek their natural levels. I suspect those levels will be much higher than they are now. It also seems unlikely the current low inflation readings will provoke the type of aggressive Fed tightening that we've seen in the past which led to inverted yield curves. It seems more likely that the Fed and other central bankers would welcome any signs of inflation.
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Chart 4
FLATTENING YIELD CURVE MAY HAVE MORE TO DO WITH EUROPE... Our final chart shows that the yield on the German 10-Year bund (blue line) started to drop much faster than the 10-Year Treasury yield (green line) during 2014. The German 10-Year yield currently sits at 0.36% versus a 2.34% yield in the 10-year Treasury bond. The spread between 10-Year Treasury and German bond yields has risen to the highest level in a decade. Meanwhile, the red line shows the yield curve in the states dropping sharply since the start of 2014, which is when the German yield starting to fall sharply as well. That suggests that a case could be made that the falling yield curve in the U.S. has as much to do with looser monetary policy in the eurozone than it has to do with threat of Fed rate hikes here in the states. It may also have more to do with economic conditions in Europe than in the U.S.
