US Outlook Report: Mystery of the Steepening Yield Curve
I guess I have been watching too many Sherlock Homes episodes on Netflix, but the sharp steepening of the U.S. Treasury yield curve since the beginning of September deserves some sleuthing. The 10-2 Year Treasury spread has increased by some 20 basis points over the last two weeks. This breaks a strong and persistent downtrend in the spread (i.e. a flattening of the yield curve) that has been underway since July of 2015.
Yield curve steepening historically has been driven primarily by signs, or expectations, of stronger growth or higher inflation. Yet we have received weaker U.S. growth signals in the economic data over the last two weeks — the drop in retail sales and industrial production for August are just the two most recent examples. On the inflation front no signs of life either. The 10-year inflation breakeven, bond investors’ estimate of average annual inflation over the next 10 years, hasn’t budged from historically low levels of 1.49% — so no explanation for the change in the yield curve there.
Perhaps heightened expectations of Federal Reserve interest rate hikes are the driver of higher long-term yields. The Federal Reserve certainly sounded hawkish at the Jackson Hole conference, and market expectation of a September rate hike from the Fed jumped to 40% for a time during the conference, only to be knocked back to earth with a weaker-than-expected August payroll report.
However, subsequent speeches, particularly from Fed Governor Lael Brainard, and continued weak U.S. economic and inflation data have poured more cold water on a September rate hike. As of Thursday’s close, the Fed funds futures market was placing just an 18% probability of a September rate hike from the Fed. Even a December hike is a less than 50-50 proposition today, in the market’s view at 49.7%. ally dovish member also made a strong case for a near-term hike Yet, the 10-year Treasury yield was still 15 basis points higher than a week ago at 1.69%. So, fear of an aggressive Fed, or imminent rate hike from the Fed, is not the driver of higher long-term rates. So we have a real mystery on our hands.
Sherlock Homes is fond of saying when you have eliminated the impossible, whatever remains, however improbable, must be the truth. By that standard of deduction, the jump in long-term rates and steepening of the U.S. Treasury curve must have more to do with what is going on abroad. Long-term bond yields have made similar moves around the globe, but the epicenter of the increases appears to center on a crisis of central bank confidence in Japan. Japanese long-term bonds have lead global yields higher. Japanese 10-year yields started rising at the beginning of August, increasing about 25 basis points and touching zero for the first time since March.
Negative interest rate policies in Japan and Europe and extensions of quantitative easing (QE) have been extremely effective in holding down global long-term bond yields. Some recent research suggests U.S. long-term treasury yields would be about 85 basis point higher today if it weren’t for monetary easing in Europe and Japan. Bond investors in Japan and Europe have poured money into U.S. Treasury bonds to attain somewhat higher returns. Those foreign capital flows are likely slowing down now.
The Bank of Japan is facing a crisis of confidence. The Bank has failed to lift inflation despite unprecedented QE and negative interest rates. There are investor concerns that the Bank of Japan is reaching its limits on its ability to purchase more long-term government debt. The BOJ now holds more than 1/3 of outstanding Japanese government bonds. Bond investors suspect the Bank may embark on a somewhat different course when its leaders meet next week to decide on monetary policy. Analyst expectations are all over the place regarding next week’s BOJ meeting. Some expect no change in rates; some are looking for a tapering of long-term bond purchases but another cut in short-term rates from -0.1% today.
Cutting short rates further but scaling back long-term bond purchases could help ailing bank margins and pensioners on fixed incomes, but probably would raise the cost of borrowing for businesses. Higher long-term rates could also become a problem for Japan’s servicing of its massive debt should rates continue to rise. With the ECB and Bank of England also holding off on further stimulus at their recent monetary policy meetings, bond investors are wondering if central banks have run out of ideas and options.
To learn more, check out this week’s US Outlook Report.
Tags: US economy, US outlook