Does The Flat Yield Curve Point To A Looming Recession? (Hint: Not Necessarily, But The Fed Is Driving The T-Curve Towards Inversion)

In the past, US yield curve inversion meant an impending recession. But not anymore in this highly-manipulated Central Bank Treasury market. But now that Cleveland Cavaliers’ star Lebron James has moved on to the Los Angeles Lakers, we can concentrate on what is important!

My former colleague at University of Chicago, Raghu Rajan, is not sure.

Is the flattening yield curve in the U.S. bond market sending signals of a looming recession? That’s still not clear, Former RBI Governor Raghuram Rajan wrote in the Financial Times.

The difference or the spread between the yield on two-year Treasury bills and 10-year benchmark bond is narrowing. It “has compressed to less than 40 basis points, he wrote. In trader parlance, that means ‘the yield curve has been flattening’, which has previously been a strong predictor of recessions,” he wrote. “Is that the case today?”

The Fed’s conviction to increase rates every quarter till the end of the next year could be one of the reasons pushing the two-year yield higher despite inflation around its 2 percent target, according to Rajan, professor of finance at the University of Chicago’s Booth School. While that should push up rates, it hasn’t.

One obvious explanation is that the European Central Bank and the Bank of Japan are continuing their quantitative easing. The sheer flow of money still pouring into the long end may be keeping yields down — after all, the five-year German Bund is at -0.3 per cent and 10-year Japanese bonds yield zero.

Rajan, however, thinks that eventually the rates would start moving up. “Perhaps it is just a matter of time before yields start moving up. This certainly is my preferred explanation,” he wrote.

To be clear, the two-year Treasury note yield is influenced by Fed monetary policy (e.g., Fed Funds Target Rate) more than the 10-year Treasury note yield is influenced by Fed balance sheet unwinding. For example, today’s 10y-2y Treasury slope has flattened -1.478 basis points. The 2y OTR Treasury yield rose by 0.020 basis points while the 10y OTR Treasury yield rose by 0.002 basis points, leading to further flattening.

curves

So while it is possible that a recession is looming, it is really The Fed that is helping drive the 10y-2y slope towards inversion.

102inersion

 

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