To Citigroup Inc., the chances are slim that the U.S. enters a recession anytime soon. Officials at the Federal Reserve feel the same way.
Yet both camps agree that an inverted Treasuries yield curve would be an ominous sign for growth. And with the latest bout of flattening, the reality of sub-zero spreads may soon collide with an otherwise sanguine outlook on the economy.
The yield curve from 5 to 30 years has flattened to about 30 basis points, the narrowest spread since 2007. From 2 to 10 years, the gap of 42 basis points is also the smallest in more than a decade. For extending to 10 years from 7, investors pick up a mere 3.5 basis points, less than a quarter of what they got a year ago.
If the barrage of Fedspeak this week is any indication, the persistent flattening is creating a dilemma for officials, who appear intent on gradually tightening policy.
On the one hand, bond traders are finally starting to come around to officials’ path of hikes, with the unemployment rate the lowest since 2000 and inflation creeping higher. But stubbornly low long-term yields could eventually force the Fed to slow down, unless policy makers are willing to push the curve below zero.
“The Fed is going to be very sensitive to the shape of the yield curve,” said Katherine Renfrew, a portfolio manager at TIAA Investments, an affiliate of Nuveen. “If we get to the point where inversion might begin to happen, the Fed may put the brakes on further dialing back monetary stimulus.”
Something will have to give — at least, if the Fed wants to keep investors from speculating that a recession is approaching. It took about six months for the curve from 5 to 30 years to flatten from around 30 basis points to zero in 2005-06. The curve from 2 to 10 years narrowed from about 40 basis points to zero in a similar amount of time. That puts both on track to invert by year-end.
“A potential curve inversion should be taken as seriously as always,” Citigroup analysts led by Jabaz Mathai wrote in an April 13 report. “The historical relationship between the curve and implied recession probabilities is highly non-linear: implied probabilities grow very fast when the curve moves into inverted territory.”
In the report, Mathai argued that the Fed is wrong on the yield curve, again. He noted that in 2006, then-Chairman Ben S. Bernanke said he didn’t see inversion as portending an economic slowdown.
Last month, current Chairman Jerome Powell said “there are good questions about what a flat yield curve or inverted yield curve does to intermediation.” Though he added: “I don’t think that recession probabilities are particularly high right now.”
At that time, yield spreads were more than 10 basis points wider from 2 to 10 years, as well as from 5 to 30 years.
Of course, a pullback could happen at any time. BMO Capital Markets strategists, who have remained firm on their forecast that the yield curve will invert in 2018, said in a note Tuesday that there could very well be “a tactical bump steeper as momentum is exhausted.”
Yet trading flows Wednesday indicated lasting wagers on narrowing spreads. For the second day in a row, a put option on the 30-year Treasuries futures contract was heavily sold, a sign of confidence that long-end yields won’t rise much. And a large block trade helped push the curve from 5 to 30 years below 30 basis points, through a key level highlighted by BMO.
That’s not much comfort for investors positioned for continued economic expansion. After the yield curve from 3 months to 10 years inverted in January 2006, it took less than two years for the Great Recession to begin.
A truly inverted curve “is a powerful signal of recessions” that historically has occurred “when the Fed is in a tightening cycle, and markets lose confidence in the economic outlook,” John Williams, the next president of the New York Fed, said Tuesday. He said that’s not the case now.
He has a point. The curve is collapsing partly because the Treasury is ramping up issuance of shorter maturities to fund expanding budget deficits.
Yet the curve from 5 to 30 years is approaching unprecedented territory. It’s on pace to flatten for nine straight sessions. The spread has only narrowed 10 consecutive times on a few occasions.
“The yield curve can’t flatten every day,” said Jim Vogel, a strategist at FTN Financial Capital Markets. “But it certainly seems willing to try.”