Flattening of US yield curve: Is another conundrum in the making? - Natixis

René Defossez, Research Analyst at Natixis, explains that since the start of the year, the slope of the 2Y-10Y segment of the US Treasury curve has flattened from 125bp to 67bp and The 30Y-10Y spread has charted a more jagged trajectory, but it has also flattened, down from 60bp to 45bp.

Key Quotes

“That there should be a flattening of the US yield curve during a monetary tightening cycle is not in the least abnormal per se: the sensitivity of bond yields to key policy rates diminishes as maturity increases. However, there are at least three factors suggesting that the yield curve might have behaved differently:

1. The Federal Reserve is proceeding very gingerly in raising the Fed Funds rate: just four hikes in the space of two years (with a long-run objective that is rather low at 2.75%), whereas during the previous monetary tightening (from 2004 to 2006), there were at least four hikes each year.

2. Since the crisis, monetary policy consists of both standard measures and non-standard measures. When the Fed Funds rate reached a floor (at end 2008), the Federal Reserve embarked on an asset purchase programme, that was followed by two others. The central bank is about to initiate a balance sheet shrink that, all other things being equal, should lead to a steepening of the yield curve.

3. The US government is expected to implement pro-growth fiscal measures.”

“In short, the normalisation of monetary policy combined with a deliberately pro-growth economic policy by the Trump administration was supposed to lead to a steepening of the US yield curve. This did unfold, but far too prematurely, on anticipation of a change in economic policy that never happened. More recently, the Treasury announcement led to an even more pronounced flattening of the curve.”

“The question now is whether there is a new conundrum in the making whereby, as between 2004 and 2006, the sensitivity of long interest rates to changes in monetary policy would be very slight or whether last year’s “false start” will be followed by a new but rather longer-lasting steepening of the curve, brought about by the restoration of term premiums.”

“The fixed income market is banking rather more on the first scenario: forward swaps suggest that the slope of the 2Y-10Y segment of the US swap curve, currently 45bp, will experience an almost linear decline to 35bp one year from now, then to 29bp two years from now. The 30Y-10Y spread, currently 22bp, would reach just 16bp in one year and then 11bp in two years. In other words, the market anticipates that, over the next two years, the 2-year swap rate will rise by 34bp, the 10-year swap rate by 18bp and the 30-year swap rate by 6bp. Forwards, as derived from the Treasuries curves, tell a slightly different story for the 10Y-2Y spread, which is expected to be relatively stable over the coming year, before subsiding.”

“On our part, we think that 2Y-10Y segment of the curve could steepen slightly to begin with, as a result of the restoration of term premiums. Despite the market not anticipating strong inflation in coming quarters and even though the Federal Reserve remains perplexed by the modest inflation, our view is that inflation premiums priced into interest rates should settle more comfortably at their long-run levels. Furthermore, hopes dashed one year go could be fulfilled this time around: as indicated above, it is quite likely that the administration will succeed in passing tax measures to stimulate economic growth.”

“All in all, this conundrum should not be for just yet, even if there exists a number of factors, often technical, that are bolstering the long end of the curve, and even though one can observe a slight convergence of historical volatility for 2-year and 10-year rates.”