Flattening is Not Threatening

This is the next thing that’s going to happen in the commentarysphere (I invented that word, it’s the new thing everyone’s doing)…

The flattening yield curve is allegedly “indicative of an expectation for continued low growth” in the economy, the whole “Trump Policies” fairy tale notwithstanding. Chronically wrong permabears with an axe to grind will be taking this concern to the next level, postulating an imminent yield curve inversion (lower rates farther out in longer maturity bonds versus higher rates in the near-term).

The psychological signal that an inverted yield curve sends is that recession is nigh, along with the historically concomitant bear market. And this would be a totally appropriate thing to worry about – just about every recession has seen an inversion in the yield curve presage it or, at a minimum, accompany it.

Here’s the thing, though – you can have a flat yield curve for a long time without an outright inversion. In fact, a flatter yield curve has historically been associated with a mid-cycle period of rising stock prices and continuing economic growth. It is not a “Four Horsemen of the Apocalypse” or “Canary in the Coalmine” sort of affair.

My friend Ari Wald, who does the technical analysis for Oppenheimer, took a look at the flatter curve over the weekend. The below chart appears amidst a 35-page tour de force backing his bullish view for the foreseeable future. If you’re not getting Ari’s stuff, it’s among the best I see each week.

Here’s his take:

Flatter Curve Not a Threat to the Cycle

The combination of tighter monetary policy by the Fed, which should lift the short-end of the US yield curve, and accommodative policy overseas, which should anchor the long-end, argues for additional curve flattening, by our analysis. However, we see below-average recession risk until the curve inverts. As it stands, the direction and the level of the yield curve is on par with the mid-1990s and the mid-2000s—prior bull market periods.

Josh here – now of course, a falling yield curve, meaning the spread between 2-year and 10-year treasury yields are narrowing – would be a precursor to an inversion, should it come, just as a ship must turn on its side on the way to capsizing.

But this ignores a few realities:

  1. The world is more global than it’s ever been before. Europe and Japan are absolutely exporting lower yields to the United States market given the relative ease of global asset allocation among large institutions. It would be a stranger thing if the US bond market were wholly out of sync with the supply / demand picture for bunds, gilts and JGBs, quite frankly.
  2. Years and years can go by on the journey from a flattening yield curve to an inverted one. The entirety of the 1995-1999 bull run for US stocks – perhaps the greatest bull run the world has ever seen – occurred during a falling spread between short- and long-term rates. During the 1980’s, the signals were all over the place, and yet stocks advanced almost as if possessed by an ancient sex demon.
  3. Yield curves flatten, widen or contract for a reason – these are man-made trends, not randomly occurring phenomena found in nature. If leading indicators in the economy are not recessionary, perhaps it’s best not to extrapolate moves in the bond market too much.
  4. Central bank buying of bonds is a major factor influencing the curve, around the world. So are the currency-management techniques of the Bank of China among others. These are technical issues, not necessarily indicative of what’s going on in our domestic economy.
  5. We also have to admit that there are some unprecedented things happen with demography, which has a substantial impact on the demand for sovereign bonds in portfolios around the world. The populations of America, China, Europe and Japan are extremely old relative to cycles of the past. What’s more, these aging people aren’t dying as quickly upon retirement, which means portfolios are being asked to do more heavy lifting to fund longer lifespans. The implication here is that perhaps the 10-year is the new 2-year in the eyes of the asset allocator. Worth considering.

A flatter yield curve is nobody’s idea of a good time. Banks make less money and are arguably more risk-averse about funding longer-term projects when there is less spread (profit) to be earned because of this “term structure” of money. However, flattening is not threatening. It’s not inverting. It’s just flattening.

There is no one who can definitively tell you for how much longer the curve can remain flattened, or what might suddenly cause a change in this trend. Further, there is not sufficient evidence from which to draw any ironclad conclusions about stock prices as a result of this activity.


Technical Analysis: Inflection Points
Oppenheimer & Co – June 17th 2017

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