The yield curve has flattened in recent months: Short-term yields have risen; long-term yields have drifted lower.
The yield on the 2-year U.S. Treasury note was 1.22% to start the year. The yield on the 10-year Treasury note was 2.45%. Today, the 2-year note yields 1.68%, the 10-year note yields 2.33%. The yield on the 2-year note is up 66 basis points, the yield on the 10-year is down 12 basis points. (Yields on 20-year and 30-years bonds are also down.)
Should we care?
We should. When the yield curve flattens, or inverts, a recession has usually loomed. The yield curve has predicted all U.S. recessions except one since 1950. The yield curve, though still normal (upward sloping), is the flattest in a decade. The last time the yield curve was this flat, an 18-month recession ensued.
A flattening yield curve can indicate that market participants are worried about the macroeconomic outlook. They anticipate a slowing economy, which would prompt the Federal Reserve to lower interest rates and provide more liquidity. Market participants sell short-term maturities and go to long-term maturities because long-term debt prices will rise more on a lower-rate trend.
That’s one reason.
The Fed simply raising the federal funds rate is another. This reason we know. The Fed has been raising the fed funds rate. It’s likely to raise it again next month.
The Fed raising the fed funds rate, a short-term rate, could constrict credit growth. Rising short-term rates coupled with falling (or even steady) long-term rates could strangle credit growth. Lenders prefer a steeper yield curve because they earn a greater spread on the price paid for funds and the interest earned lending those funds long term.
So, does this mean the good times will soon end?
Not, necessarily. This time is different. Then again, this time is always different.
A flatter yield could be the new normal. Few market participants before 2008 would have expected the Fed to hold the fed funds rate at close to zero, which it did for six years. That was an unprecedented new normal. Asset prices re-inflated while consumer-price inflation remained remarkably muted.
The flattening yield curve also could be nothing more than a supply-demand reaction. The U.S. Treasury Department has said it wants to shift the focus to short-term debt. It wants to issue more bills and 2-year and 5-year notes and fewer long-term notes and bonds. More supply on the short-end requires higher yields to draw more demand.
Our take is that things don’t feel “recessiony,” as unscientific as that explanation is. We still have low inflation, solid corporate earnings growth, persistent employment growth (with low wage inflation), and a lot of folks worried about the flattening yield (a good thing).
We see business as usual. Business as usual includes mortgage rates holding a tight range through the remainder of the year, with the range possibly holding into 2018. The range has held 3.875% to 4.125% on a prime 30-year loan. We expect more of the same.