Flattening US yield curve could spell trouble ahead ....

Friday 8th January 2016

Flattening US yield curve could spell trouble ahead ....

ref :- "Short View", the Financial Times, Companies and Markets

It's tempting to say that with Chinese markets enjoying a welcome respite today from the recent blood-letting, we'll take the opportunity to look at an entirely different topic. It wouldn't be entirely true of course. Everything is connected and China's economic fortunes certainly have a big part to play in US bond markets, but still .....

Much is being made of the flattening of the US yield curve. We know that in normal circumstances the yield curve would be an upward sloping beast quite logically representing the fact that investors desire a higher return the longer the term of their investment. The Fed's rate hike last month obviously pushed up the rates for short-term vehicles but the yields on Treasury notes and bonds further down the range of maturities have fallen since the Fed move. The yield on the 10yr note has fallen from 2.29% to 2.16%  --  that may not sound like a lot to the layman but at a time when short-term money has been marked higher this is a big deal. The spread between yields on the 2yr and 10yr T. Notes is now below 1.2%, the narrowest since early 2008.

Why ? You could look at it as a simple matter of supply and demand. The US Treasury has a fairly heavy schedule of short-dated T. Bill issuance but the continuing the process of cutting the budget deficit will shrink the supply of longer-dated paper. And on the demand side, market ructions  --  particularly in China (see .... you can't get way from it)  --  promote safe-haven buying of secure government debt.  In addition, the market plainly does not believe the Fed's warnings both of inflation and of a consequent full percentage point's worth of rate hikes this year (China prominent in the market's mind again). Investors have been locking in the yield, historically low though they are, while they can.

What does it mean ? Well, for one thing it means that whilst the Fed may control the level of short-term rates, patently the same cannot be said of the longer end. But more worryingly, the records show that flatter yield curves are BAD NEWS ..... they tend to point to oncoming recessions. You could argue that whilst the US recovery since the post-Lehman trough may not have been spectacular in terms of pace, it has been going on a very long time  --  79 months of economic expansion, to be exact. 

As the FT puts it, expansions don't just die of old age but the pessimists will point to other measures that should be getting our attention : the ISM manufacturing index at its lowest since 2009, and a faltering corporate bond market. Some of the shrewdies like to follow the Dow Jones Transportation index for an insight as to how the economy is really going  --  for a really ugly picture, have a look at that chart.

So there you have it ..... if we were looking for a little light relief in turning our attention away from China, it's in short supply apparently.

And on not entirely unrelated matters .....

We suspect that by the time many of you get to read this, December's US Employment data will already have been released. No matter, you can still compare the numbers to the market's consensus forecasts :

Non - Farm Payrolls :           215,000

Unemployment Rate :          5.0 % (unch)

Average Hourly Earnings :   +0.2%

Much attention will be on the Hourly Earnings figure. With the Chinese economic slowdown meaning reduced demand and crashing commodity prices, the Fed is of the view that the driver for a pick-up in inflation will be upward wage pressures brought on by a tight labour market. Not everybody is convinced .....