US Yield Curve: Flattening but not fearfully flat – BMO CM
The US Treasury yield curve continues to flatten and last week, the well-watched spread between 2- and 10-year yields slipped under 60 bps, the smallest since October 2007 and before the Great Recession began, explains Michael Gregory, Deputy Chief Economist at BMO Capital Markets.
“Since Treasury started issuing 2-year securities back in 1976, 2s10s has flattened and eventually inverted ahead of each of the past five recessions. There’s a reason why a version of the yield curve is included in the index of leading indicators. As was the case in each of the prior episodes, a catalyst for the current flattening trend is Fed rate hike expectations. But, we would be very cautious in concluding that any specific spread level today conveys the same recession risk signal it once did.”
“Through three rounds of quantitative easing and an “Operation Twist”, the Fed spent years working at making the yield curve flatter than it otherwise would be. The Fed’s $2.5 trillion portfolio of Treasuries is skewed towards longer maturities. Although reinvestment tapering began last month, the Fed’s massive holdings will continue to exert a flatter-than-otherwise influence on the curve for some time to come.”
“Also, the past flattening episodes all involved the situation in which the market began to increasingly bet that the Fed had tightened too much and would, in relatively short order, have to reverse course. This resulted in the spread between fed funds and 2year yields turning negative, before or as 2s10s moved to inversion. Assuming the FOMC raises rates next month, this would make five rate hikes spread over 25 months (a 2½-moves-per-year pace), with the dot plot showing that the Fed might pick up this pace a bit next year (to 3, although the market is pricing in less).”
“Previous tightening campaigns occurred much more quickly, which, given the lags in how rate hikes work their way through the economy, necessarily meant higher risks of tightening too much compared to the current situation. The spread between fed funds and 2s is currently about +60 bps. Indeed, the spread between fed funds and 10s currently hovers around 115 bps, close to its historic median, and with plenty of flattening room left before sounding any recession alarms.”