Don't fear the flat.
The gap between short and medium-term bond yields continued to narrow Wednesday, raising further concern that the so-called yield curve could be warning of a potential U.S. recession, even as investors debate the efficacy of its predictive abilities in a market where the safest investments offer significantly higher yields than riskier assets in other parts of the world.
Preparing for recession amid one of the most impressive growth spurts of the past ten years -- the Atlanta Fed's GDPNow indicator suggest the economy is growing at 4.6% clip; the S&P 500 I:GSPC is set to breach the 2,900 point mark for only the second time ever and headline unemployment sits at a decades-low 3.9% -- is a counter-intuitive task, but it certainly seems to be on the mind of a certain set of investors. Benchmark 10-year U.S. Treasury bond yields were marked 1 basis points lower at 2.88% in early European trading, while 2-year notes were marked at 2.67%, putting the slope of the yield curve at a mere 0.21%, near the narrowest since the peak of the global financial crisis in 2008.
The peculiar arithmetic of fixed-income investments basically makes short-dated bonds more sensitive to interest-rate changes. So when short-term rates spike, that means traders are anticipating higher rates from the Federal Reserve. But when, at the same time, they're also worried about longer-term growth, they'll still buy 10-year debt, pushing prices higher and yields lower and thus "inverting" the curve. An inverted yield curve has also been an uncanny predictor of recession, according to data from the St. Louis Fed, foretelling each and every pullback in economic growth for the past 60 years.
Not everyone is convinced that bond traders are the soothsayers they claim to be, however, including U.S. Treasury Secretary Steven Mnuchin, who told CNBC Tuesday that he was "not at all concerned" about the shape of the yield curve.
"I don't think that's a predictor of economic growth. I think it's a market condition," he said. "For now, having a flat yield curve with us issuing long-term debt is something we're perfectly content with."
It would be easy to dismiss Mnuchin's comments as being tainted by the bias of his boss, given President Donald Trump's stated dislike of the Fed's current interest rate policy and his constant references to the "best economy ever" on his Twitter feed, but he does have a point.
With Italy's new government threatening to breach its agreed deficit targets, and Turkey's currency crisis sapping sentiment around the region, investors are retrenching into the safety of Eurozone government bonds, keeping yields -- and potential returns -- at historic lows.
Benchmark 10-year German bond yields, a proxy for risk-free interest rates in the Eurozone, were marked at 0.38% Wednesday, giving investors the chance to take a stronger currency (one euro buys 1.16 U.S. dollars) and purchase 10-year Treasury notes that yield 2.86%. That's a 2.48% return swing into one of the world's most liquid markets adds no risk to a particular portfolio. It's even more extreme for investors holding Japanese government debt, which gives you paltry 0.09% annual return.
The attraction of both trades was party on display earlier this month, when Treasury International Capital data showed a net increase in foreign purchases of U.S. assets neared $420 billion in the second quarter, with June inflows of $114.5 billion.
That dynamic alone is strong enough to keep 10-year yields firmly below the 3% threshold, while the Fed's signalling of gradual rate hikes continues to push two-year bond yields higher. In fact, the CME Group's FedWatch tool suggests traders are pricing in a 70.1% chance of a December move that would take the FedFunds rate to between 2.25% and 2.5%.
Furthermore, argues Jeffrey Rosenberg of BlackRock, as the Treasury sells a greater proportion of short-terms bonds to fund the $1.5 trillion in Republican-led tax cuts, short term rates have risen while longer-term rate have held steady. Meanwhile, he notes, "the Fed is maintaining its long-term bond holdings, rather than actively selling them" as it winds down its balance sheet as part of its exit from quantitative easing. "And it is still reinvesting a portion of its maturing bond holdings, while allowing the rest to run off at maturity."
If the U.S. economy continues to ride the gains of President Trump's tax cuts, not to mention the 20%-plus earnings growth recorded over the past two quarters, those FedWatch percentages, not to mention two year bond yields, will rise in unison. And if Europe's problems persist -- and the European Central Bank maintains its vow to keep rates low until at least next fall -- the attraction of risk-free U.S. Treasuries will be difficult to resist.
That could potentially invert the yield curve. But it won't signal recession.