Let’s not get too bent out of shape about the US Treasury yield curve. The steepness of the curve, as often measured by looking at the difference between the yield of the 2yr and 10yr maturities, has been on the decline for some time. The difference now rests below 0.7%, well below the 2.5% spread that existed at the end of 2013 when extraordinary US monetary policy was still well under way. This makes a lot of investors nervous since an inverted yield curve (when the yield of the longer maturity exceeds the shorter maturity) has been associated with economic recession. The “rule of thumb”, according to research by the Cleveland branch of the Federal Reserve, is that an inverted yield curve indicates a recession in about one year and it has preceded each of the last seven recessions. With US equity valuations being so full, any twinge of a possible downturn in profit leaves the market jittery.
We are certainly mindful of the US Treasury curve and its forecasting ability, but we are not sounding the alarm bells just yet. In our view, the yield curve is flattening because the Fed continues to normalize (increase) short-term rates while wage growth (a sustainable driver of inflation) has been range bound between 2% and 3%. Therefore the short-end of the curve is coming up while the back-end stays put leading to a flattening. There is a big difference in forecasting between a flattish (but still positive) curve and a truly inverted curve. Again looking to the Cleveland Fed, their forecast for recession in the next year given the current yield curve slope is between 10-15%. Also, while high yield spreads have widened a bit in recent weeks they are still hovering around 3.8% – certainly not at a level which suggests a fear of defaults and almost 1% lower than it was just a year ago. For now, it does not look like economic growth is going to fall down the slope.