According to Richard Franulovich, Research Analyst at Westpac, the persistent flattening in the US bond curve is a major focal point at the moment and to the extent that the curve is a proxy for the stance of US monetary policy it is associated with easier growth and higher risk premiums in the future and a higher USD.
“The most likely factor driving the flattening in the curve seems to be Fed hikes in a low inflation environment. As slide one shows the US curve has a strong inverse relationship with the real Fed Funds rate. In the post crisis era core PCE has trended sideways, ranging between 1% to 2% for an average 1.6% pace. It could easily remain sub-par for another year or two - after all it has shown absolutely no tendency to accelerate over the last five years. Against that the Fed’s dots point to another 5+ Fed hikes in 2018 and 2019. That is predicated on higher inflation but if the Fed were to pursue that much tightening in a persistently sub-par inflation environment real Fed Funds will move significantly higher and in all likelihood invert the curve.”
“To the extent that the US curve is a proxy for the tightness of policy it is understandably a leading indicator of US growth. Slide two shows the US curve leading US growth by around 18 months. The relationship is far from iron clad though – the mid-1990s saw a significant flattening in the US curve but GDP growth was very strong amid the new economy and productivity boom then.”
“The curve appears to be a decent leading indicator for risk premiums too. Taken at face value the flattening of the US curve points to a meaningful trend increase in volatility in the next couple years, though as above the apparent strong relationship is because the curve is a proxy for the stance of monetary policy and growth.”
“Given all the above it should be no surprise that curve flattening coincides with USD appreciation.”
“Overall the flattening in the US curve is mostly an outgrowth of Fed hikes in a low inflation environment and with that in mind tends to be associated with lower growth and higher risks premiums in the future and a higher USD.”
Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these securities. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Forex involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility.