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Trouble With The Curve

Thursday, December 21, 2017

When what is supposed to be a curve is more akin to a flat line, it can be interpreted as a sign of trouble ahead, as GAM’s Julian Howard explains.

The US Treasury yield curve may sound like another mysterious financial term known only to a select few, but the spike in the Google search frequency of the term “yield curve flattening” reveals that many are concerned about it, and rightly so. Historically, the yield curve – the difference between short and long-term interest rates – has tended to be a bellwether for what happens next in the real US and global economies. A steep curve in which long-term interest rates are much higher than short-term ones is deemed a healthy state of affairs, since long term interest rates reflect higher anticipated growth and inflation than currently prevails. But a flat or inverted curve suggests the opposite, with future growth and inflation expected to be unchanged or even lower than at present. No surprise then, that flat and inverted curves have been associated historically with economic slowdowns. In the US, future consumer expectations have also been closely linked with the shape of the yield curve and both have proven to be reliable indicators of imminent recession (see chart). Today, as the yield curve flattens once again, the real question for those frantically searching on Google is whether the indicator should continue to be trusted and how best to respond to it.

Reliable indicator: the yield curve and consumer expectations have foretold recessions
From 30 Nov 1977 to 30 Nov 2017
Chart 01

Past performance is not indicative of future performance.
Source: Bloomberg, Conference Board

To understand what the yield curve is telling us today, we first need to break it down into its two component parts. The so-called ‘short end’ can be taken to be the 2-year US Treasury bond yield while the ‘long end’ of the curve can be taken to be the 10-year US Treasury bond yield. The short end essentially reflects expectations of near-term interest rates as set by the US Federal Reserve. Today, those expectations are elevated. The Fed Chair elect Jerome Powell appears keen to raise interest rates, stating at his recent Senate hearing that the case for monetary policy tightening is “coming together”. While the wisdom of such a pre-determined path in the face of low inflation could be questioned, short-dated Treasury yields have rushed to price in this more hawkish interest rate path.

But it is the long end of the yield curve that is of more interest. Traditionally, the 10-year US Treasury yield has comprised expectations for economic growth, inflation and a small risk premium. For the US therefore, the yield should theoretically be at around 5%, i.e. future growth of 2.5%-3% plus 2% inflation and some risk premium. However, it has not actually been above 4% since the end of 2007. Two decades of declining inflation and disappointing growth cannot alone explain why the yield is so low today.

Key to the mystery is the fact that, since the late 1990s, economies which benefited disproportionately from globalisation and rising oil prices have recycled their gains into US government bonds. Unsurprisingly, this ‘global saving glut’ has been pushing bond prices up and yields correspondingly lower, creating the pre-conditions for a flatter yield curve. However, this still cannot be the entire story, since the saving glut has diminished in line with falling oil prices in recent years. In fact, yields have been suppressed recently because there is a new bond buyer in town: many US firms have been pouring surplus cash into their pension funds amid worries that tax breaks on pension contributions could be withdrawn as part of incoming tax reform. Given the ageing population in the US, it is then no surprise that most of these flows end up in safer US Treasuries rather than riskier equities.

Benefit of low bond yields: higher ERP has tended to bode well for equities
From 31 Dec 1999 to 15 Nov 2017
Chart 02

Source: Bloomberg, . *Defined here as S&P 500 forward earnings yield – 10yr UST yield, %

In some ways, this is quite encouraging because low Treasury yields reflect a unique technical phenomenon rather than a gloomy economic outlook. This fits in with the wider economic evidence too. US business investment is rising, unemployment is low and any tax deal should be growth-positive. There is also a happy side benefit for equity investors from these lower bond yields: the larger the gap between equity earnings yields over bond yields (the equity risk premium or ERP), the better the subsequent returns from equities.

This makes sense since, given the choice of two yields, investors will rationally tend to go for the higher after adjusting for the relative risk of holding equities. Investors can therefore rest easy that the yield curve is probably distorted this time around and that equities may stand to benefit. However, some caution is still warranted in the months ahead given the decline in future consumer expectations (per the first chart above). Even if there is ‘trouble with the curve’, the US consumer’s instincts about the future are not so easily dismissed. With consumption representing such a large proportion of the economy, any pessimism could ultimately become self-fulfilling.

Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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