For the 10-year Treasury note, climbing above a 3% yield, and staying there, is a daunting piece of aeronautics.
If the 10-year—which is the benchmark for fixed-income throughout the financial world—can’t rise a meaningful distance above 3%, trouble could be in store: A stalled 10-year yield enhances the odds that government bonds would end in the dreaded inverted yield curve.
An inverted yield curve is where short-term government debt yields more than longer-maturity bonds, a condition that signals the onset of a recession.
Threat of an Inverted Yield Curve
When short-term rates are higher than long ones, market sentiment holds that the economic outlook is poor. Every recession since 1955 has been preceded by an inverted yield curve, with only a single false reading (in the mid-1960s), according to the Federal Reserve Bank of San Francisco.
Of course, market dynamics this time around are dramatically different than they have been in previous economic cycles. A decade after the financial crisis, markets are exhibiting many peculiar – even paradoxical – indicators. The prospect of an inverted yield curve comes even as economic activity remains vigorous and the Fed plans to raise short rates. Global uncertainty and safe haven status, meanwhile, is pinning down the long end of the curve.
Still, the inverted yield curve has a track record that merits watching and could be signaling the end of an economic expansion some market forecasters say is long in the tooth.
“The inverted yield curve tells us a recession is on the way in 12 to 18 months,” said David Ader, chief macro strategist at Informa Financial Intelligence, who pointed to “unhealthy signs” that the lengthy economic expansion since March 2009 might be stuttering toward a close.
Current harbingers of such a downturn, he said, are: the prospect of a devastating trade war; corporate products puffed up by the recent tax cut, which otherwise “would be flat”; and companies’ reluctance to significantly boost capital spending or employee pay and training. “That indicates they aren’t optimistic,” Ader contended.
For sure, the curve nowadays is flattening. The spread between the two-year and 10-year Treasurys is 0.44 percentage point. At the end of 2015, it was 1.43 points.
The dynamics of short- and long-term Treasury yields are different, which is a big reason for the spread compression and contraction.
The short-term paper’s yield is driven mostly by the Federal Reserve, which these days is embarked on a campaign to restore short rates to a more normal level, from near-zero in the aftermath of the financial crisis. The Fed wants to set rates high enough so it has room to lower them again to combat a recession, which it did in the wake of the 2008 debacle.
“When the Fed raises the federal funds rate, the two-year Treasury rises almost in lockstep,” noted a research report from Delta Investment Management. Assuming the central bank hikes the federal funds rate by a quarter-point on Wednesday, as is widely expected, you’ll likely see the two-year Treasury move to 2.75% from 2.5%, the paper read.
The fed funds rate now is in a 1.5% to 1.75% band. Five more such increases would put it at 3%, which would mean parity with the 10-year, if the note remains there. And the two-year yield would be higher, perhaps as much as 4%.
The Curse of the Haven Bond
The 10-year yield isn’t directly affected by the Fed. Its yield moves primarily due to two competing influences, inflation and the bond’s haven status.
Upward pressure on the yield comes from prospects for higher inflation, and the Consumer Price Index has been inching upward in recent months. But then there’s periodic downward pressure on the yield from the popularity of the 10-year as a haven bond for international money if conditions get shaky overseas. Big foreign buying, of course, pushes up bond prices, which leads to lower yields.
A recent example of this haven-bond phenomenon came last month, after the 10-year finally crawled above 3.1%. Its stay at that level was brief. An attempted Italian governing coalition fell apart, which shook some investors’ faith in Europe’s common currency. The news created a rush into the Treasury bond, and its yield slid back down below 3%. “Italy provoked a violent flight to quality,” said Chris Brown, a vice president at T. Rowe Price Group and co-portfolio manager of its Total Return Bond Fund.
The Italy development pole-axed some fixed-income investors. Bond guru Bill Gross’ flagship fund, Janus Henderson Global Unconstrained, bet the wrong way on European bonds – that German bond prices would drop compared to Italian paper. But after the Italian coalition fracas, the Gross fund slid 3%. (The fund since has partially recovered. And the Italians seem to have formed a new government.)
The 10-year Treasury gives comfort to investors because they view it as risk-free, thanks to Washington’s taxing authority over the world’s largest economy. When S&P lowered the US government’s credit rating in 2011, because of a federal budget impasse, US yields didn’t shoot up, noted Eddie Hebert, a managing director at investment manager PPM America. “That means investors still see America as a safe haven.”
Plus, the US economy is faring better than most others now, so its benchmark bond’s yield tends to be higher, thus making the obligation even more attractive. Stepped-up buying “has put further drags on the 10-year Treasury’s rise” on yield above 3%, said Matthew Merritt, global head of multi-asset strategy at Insight Investments.
Look at the 10-year government bond yields of America’s G-7 partners. With the exception of crisis-wracked Italy (yield: 3.11%), they all trail the Treasury note, with Canada’s yield the highest (2.35%) and Japan’s the lowest (0.5%), according to Bloomberg data.
The Upward Pressure
The case for powering past the 3% ceiling hinges on continued American economic growth and its usual handmaiden, quickening inflation.
Assuming that current economists’ projections are correct, and the US won’t slip into a recession for a while, a moderate ascent in inflation might be enough to finally push the 10-year yield above 3% and keep it there.
Economists polled by the Wall Street Journal expect inflation to hit a 2.5% annual rate in April this summer, up from 1.6% at mid-year 2017. It is anticipated to ease off a bit to 2.2% next June, but that’s still higher than the 1.32 annual CPI average for the five years ending in 2017. A sign of the times: Social Security recipients, who for years have endured miserly inflation adjustments to their payments, recently got a decent 2% raise, Loreen Gilbert, president of WealthWise Financial Services, pointed out.
“The Fed is letting inflation run a little hotter now,” said Charlie Ripley, senior investment strategist for Allianz Investment Management, one reason he expects the 10-year might hit 3.25% this year.
Another factor in the higher-yield scenario is an upcoming avalanche of new federal debt, the result of higher spending and the new tax cut. The Treasury Department just estimated that its borrowing needs this year will expand to almost $1 trillion, up from $519 billion last year, with similar high needs over the next two years. In addition, the University of Pennsylvania’s Wharton School figures that the tax reductions will require another $2 trillion in debt this decade.
“Who will buy that $3 trillion to $5 trillion in new debt, and at what rate?” asked Dave Haviland, a managing partner at Beaumont Capital Management. The upshot of more bonds available: lower prices and loftier yields. As a result, he thinks the 10-year could rise as high as 3.75%.
Should that happen, the hope is that the Fed won’t boost short rates beyond that point, producing an inverted yield curve. “The big concern,” Haviland said, “is a Fed policy mistake.”