US: Yield curve put under the microscope? - Natixis

René Defossez, Research Analyst at Natixis, notes that the slope of the US yield curve has continued to flatten in recent trading sessions: the slope of the 2Y-10Y segment of the Treasury curve is now just 62bp (its lowest level since 2007), while it is only 42bp for the 10Y-30Y segment (its lowest level since 2008).

Key Quotes

“Some market participants expect a new “conundrum”, referring to a situation in which long interest rates are largely unresponsive to changes in monetary policy, which in time could lead to an even more pronounced flattening of the yield curve. Several factors suggest as much, in particularly the issuance policy of the US Treasury next year, the behaviour of certain non-resident investors (who have shown a keen appetite for US Treasuries of late) and, more generally, the fact that the slope of the yield curve is cyclical in nature (i.e. flattens when key policy rates rise). There are also factors suggesting quite the opposite, notably the likely implementation of pro-growth fiscal measures and the restoration of term premiums.”

“There could be something to glean from looking in more detail at the behaviour of the components of nominal interest rates, namely real rates and breakeven inflation rates, so as to attempt to anticipate the future behaviour of the yield curve slope. What is striking right off is that after a prolonged period of growth, at a time when, perhaps, the US economy is near the end of its current cycle, these components are still far removed from the levels observed at the end of the previous cycle, which came to an abrupt end because of the financial crisis.”

“Currently, the real 2-year rate hovers around 0% (+0.27% currently, but it was in negative territory a fortnight ago), and sits just below the real 10-year rate (0.48% currently). In 2007, just before the crisis, the 2-year was near 3%, at nearly the same level as the 10-year.”

“In 2007, as the 2-year and 10-year breakeven inflation rates were at much the same level, the yield curve was extremely flat: this configuration was explained by the aggressive normalisation of the Federal Reserve’s monetary policy, at a time when non-resident investors displayed a keen appetite for long-dated US Treasuries. Currently, breakeven inflation rates are lower and not pegged at the same level (breakeven for the 2-year TNote is 1.48%, while for the 10-year TNote it is 40bp higher). An around 60bp spread between the 10-year and 2-year rates remains in evidence, which therefore results from: 

• The hierarchy between inflation premiums, which is a function of duration; and
• The hierarchy between real interest rates, which is also a function of duration.”

“However, this is also explained by the Federal Reserve’s monetary tightening being conducted extremely cautiously, the pace being half that of the previous monetary tightening cycle.”

“As to whether the slope of the 2Y-10Y segment will steepen or flatten, one needs to answer the following questions:

1. Will the Federal Reserve up the tempo of its monetary tightening? The answer is probably no. In the absence of an endogenous inflationary risk, the central bank has no reason to proceed more quickly (the Phillips curve is flat or near enough);

2. Will non-resident investors reach out for long-dated US Treasuries? It is likely that the stock of US TNotes and TBonds held by bon-residents (currently around $3,745bn) will continue to rise, but appetite for US Treasuries is likely to be less than it was 10 years ago.

3. Will the slope of the breakeven inflation curve remain positive? Yes in terms of trend, but of course breakeven inflation rates will remain more volatile at the short end than at the long end. In coming years, the inflation risk will remain weak, but the market will continue to anticipate a normalisation, i.e. a lasting return to 2%, over the long run.

4. Will the slope for real interest rates remain positive? Yes, at least to begin with. The Federal Reserve’s balance sheet policy will lead in priority to a restoration of the term premiums of long-dated Treasuries.”

“Can these four factors offset those favourable to a flattening of the yield curve mentioned above? We think so, bearing in mind a steepening of the yield curve will be facilitated by the fiscal policy of the US government. At the end of 2016, similar expectations at fiscal level led to a 70bp rise in the spread between the 10-year and 2-year rates.”