In at least the long end of the yield curve’s slope, the feared recession indicator isn’t forecasting doom and gloom for the U.S. economy, despite fears it will join the doldrums felt by the rest of the world.
Assessed by the yield spread between short and extended maturity bonds, gauges of the curve’s slope using the 30-year bond as have gradually widened, or steepened, even as more conventional measures based off the benchmark 10-year note remained close to its flattest levels since 2007.
Market participants say the contradictory signals sent out by different measures of the yield curve in part reflect Wall Street’s expectations for a more patient Federal Reserve that will stir the U.S. expansion and inflation back into life. At the same time, global growth concerns have aroused enough worries that bond investors aren’t willing to take bets on a U.S. slowdown off the table, putting a lid on longer-dated yields.
“You have a tradeoff going on in the economy where investors are weighing international considerations versus domestic considerations,” said Steven Ricchiuto, chief U.S. economist for Mizuho Securities.
Analysts say a flattening slope can indicate concerns that the Federal Reserve’s rate hikes, lifting the short end, will weigh on the economy and inflation, capping the long end. However, a steeper curve can suggest expectations for a pickup in growth. To be sure, the yield curve’s predictive powers have only borne fruit when the spread between short-term and long-term yields is reduced to nothing, or has turned negative.
The widely-watched spread between the 10-year note TMUBMUSD10Y, +0.65% and the two-year note TMUBMUSD02Y, +0.66% stands at 17 basis points, or 0.17 percentage points, slightly above the 14 basis points it was at on Dec. 20. Meanwhile, the gap between the 30-year bond TMUBMUSD30Y, +0.35% or the long bond, and the two-year note stood at a roomier 56 basis points, compared with 34 basis points on Dec. 20, Tradeweb data show.
Investors say the robustness of inflation expectations meant the benchmark 10-year note rallied further than the 30-year bond when investors dived into the perceived safety of U.S. government paper at the end of 2018. Since both maturities reached their multiyear highs in November, the benchmark Treasury note retreated 60 basis points to 2.643%, while the 30-year bond has fallen around 40 basis points to 3.033%. Bond prices move inversely to yields.
That, in turn, drove wider spreads in yield-curve measures using the long bond, versus those employing the 10-year note.
Traders tend to monitor the 30-year bond more so than the 10-year note to assess investors’ prospects for inflation as the long bond is less affected by the expected path for interest rates compared to the benchmark note, said Ricchiuto.
The 10-year break-even inflation rate, or what bond investors expect consumer prices to average for the next decade, has climbed back to 1.91%, after falling as low as 1.68% on Jan. 3.
Even as many forecast weaker U.S. growth, some investors — like Ricchiuto — said the Fed’s decision to signal a more patient stance on further rate moves at its January meeting would give the U.S. economy enough breathing room to allow wage and inflationary pressures to build up.
This, in turn, would steepen the yield curve as a less aggressive Fed would prevent short-end yields from rising, while higher prices tend to weigh on fixed-income payments for longer-term bonds vulnerable to the corrosive impact of inflation, pushing such yields higher.
As a result, calls for a steeper curve may have showed up first in the spread between the two-year note and the 30-year bond, and not in the spread between the two-year note and the 10-year note.
Bets on a pickup in prices also gained momentum after Fed Chairman Jerome Powell told Congress in February that the central bank could tweak interest-rate policy to allow prices to overshoot its 2% inflation target to make up for any shortfalls when growth is slow.
The long end of the bond market may reflect fears that “abandoning the inflation target, or looking for wider bands” will increase the term premium, or the extra yield investors demand to own longer-dated bonds to compensate for the risk of inflation and interest-rate moves moving in an unpredictable direction, said Marvin Loh, senior global markets strategist at State Street.
Yet others, like Deustche Bank, think the long bond’s more muted rally relative to the benchmark 10-year note late last year is due to a more mundane reason — a pullback by corporate pension funds.
Managers of corporate pension plans are one of the chief buyers of the 30-year bond because they need to match their extended liabilities with assets that can pay out for a long time.
This dependable source of demand, however, softened up after tax deductions available to corporations depositing money into their employees’ pension pots ended in September, according to analysts at Deutsche Bank.
In addition, risk assets have yet to make up for the lost ground at the end of the year following a stock-market selloff in December. Corporate pension funds didn’t have as much to rebalance toward their portfolios’ bond allocations after its gains from a multiyear bull market were partially erased. Last Friday, the S&P 500 SPX, +1.47% finished 6.4% below its record close in September.