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What's Worse: Flattening Yield Curve or Rising Bond Yields?

What's Worse: Flattening Yield Curve or Rising Bond Yields?
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Monday, 23 April 2018 01:32 PM Current | Bio | Archive

What are stock investors rooting for in the fixed income markets? Stock investors have been fretting lately about the flattening of the yield curve.

If it inverts, they’ll be thrown into a frenzy; fearing that has always signaled an imminent recession. The yield curve spread between the 10-year US Treasury bond yield and the federal funds rate narrowed significantly after the Fed’s latest rate hike on March 21. Last week, it widened as the bond yield jumped 14bps to 2.96%, the highest since January 9, 2014 (Fig. 1 and Fig. 2). Stock investors didn’t jump for joy. Instead, they fretted that the bond yield was approaching 3.00% and could soon breach that technically important level.

So what do stock investors want? I suppose they would be very happy if the Fed stopped raising the federal funds rate and the bond yield stabilized. But that’s not going to happen because Fed officials are intent on normalizing the federal funds rate so that they will have more room to lower it to avert the next recession.

Isn’t that a bullish scenario for stocks in the long run? That’s a rhetorical question. The longer the Fed can keep the expansion going, the more bullish that should be for stocks even though the short-term increase in interest rates creates somewhat more competition from bonds in this scenario. Besides, the Fed’s ongoing tightening confirms that the economy is strong enough to absorb the gradual normalization of monetary policy.

If the yield curve were to steepen, with bond yields rising faster than short-term rates, then we would have to worry that the Fed is “behind the curve” in keeping a lid on inflation. The most recent behavior of the yield curve suggests that the Fed is doing the right thing, i.e., keeping inflationary pressures in check.

Debbie and I continue to expect that the 10-year yield will trade mostly between 3.00% and 3.50% over the rest of the year. We expect that the Fed will raise the federal funds rate range three more times this year at the June (1.75%-2.00%), September (2.00-2.25), and December (2.25-2.50) FOMC meetings (Fig. 3). Meanwhile, the Fed has started to reduce its holdings of US Treasuries, which are down $53 billion over the past 25 weeks through April 18 (Fig. 4). Over the course of the current fiscal year (from October 2017 through September 2018), the Fed expects to reduce its Treasury portfolio by $180 billion. Recall that the Congressional Budget Office is projecting a federal budget deficit of $804 billion during fiscal 2018, up $138 billion from fiscal 2017.

These are all potentially bearish developments for the bond market, for sure. However, they have been widely known. The jump in bond yields late last week was fueled by a jump in inflationary expectations, triggered by a jump in some commodity prices. Let’s have a closer look:

(1) Inflationary expectations and commodity prices. Last week, the 10-year bond yield rose faster than its comparable TIPS yield (Fig. 5 and Fig. 6). So the 10-year average inflation rate implied by the spread between these two yields rose to 2.17%, the highest since September 4, 2014, which is when the price of oil and other commodity prices went into a freefall.

There is a high correlation between this measure of inflationary expectations and both the price of a barrel of Brent crude oil and the CRB raw industrials spot price index, which doesn’t include oil (Fig. 7 and Fig. 8). While the price of oil jumped last week, the CRB raw industrials spot price index remained listless. The former gets lots of media attention, while the latter does not.

However, the price of nickel, which is not included in the CRB index, did soar last week on concerns that Russian nickel producer Norilsk Nickel will be included under US sanctions on Moscow that have already led to a rally in aluminum prices, which is also not in the CRB. The price of copper is included in the CRB index, and it is also highly correlated with the expected inflation series (Fig. 9). However, the price of copper remains stalled around $3.00 per pound, as it has been since late 2017.

The bottom line is that the bond yield jumped because inflationary expectations jumped mostly on a jump in the price of oil. The latter has been surprisingly strong, as we discuss in the next section. Debbie and I believe that it reflects the strength of the global economy. We aren’t concerned that it will push up the core inflation rate (excluding energy).

(2) Credit quality spread and leading indicators. If the global economy is doing well, why has the US yield curve been mostly flattening so far this year? It’s hard to imagine that the global economy would be prospering if the US economy is on the verge of a recession. Reflecting domestic economic strength, US imports have risen to record highs this year, certainly boosting the global economy.

An even more reliable signal of an imminent recession is the yield spread between the BoAML high-yield corporate bond index and the 10-year Treasury (Fig. 10). Since the start of 2017, it has been remarkably subdued near previous cyclical lows. Keep walking, folks: There’s no recession here.

There’s also no recession in the Index of Leading Economic Indicators (LEI), as Debbie discusses below (Fig. 11). The LEI rose to a record high during March. On average, it tends to top three months before recessions. Occasionally providing even earlier signals of a recession is the ratio of LEI to CEI, i.e., the Index of Coincident Indicators (Fig. 12). It has been soaring over the past 15 months through March, yet it still remains below the previous two cyclical highs.

(3) Foreign yields. Despite all the commotion in the US government bond market, government bond yields remain subdued in Germany (0.47%) and in Japan (0.04). While the Fed has started to taper its balance sheet ($4.4 trillion in March), the assets of the ECB and BOJ rose to new record highs in March of $5.6 trillion and $5.0 trillion, respectively.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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What are stock investors rooting for in the fixed income markets? Stock investors have been fretting lately about the flattening of the yield curve.
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Monday, 23 April 2018 01:32 PM
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