Should we be worried about the flattening yield curve in the US? Not too much

My short answer is not too much.

While I am not arguing for complacency, the worries that the yield curve in the US signals an impending recession are overdone. The bond yields movements of this week seem to clearly confirm that: Mario Draghi’s comments pushed long-term European yields up and this spilled over to the US treasury yields which also went sharply up.  This is the clearest sign that the real picture of growth and inflation expectations in the US is different from what the flattening yield curve was suggesting. It also shows that that the distortion in the US yield curve is at least partly caused by the ultra low yields on European bonds and the resulting chase for yield.

Since the Fed started raising the overnight interest rates, the yields on longer dated bonds have been falling, thus causing the yield curve to flatten. Ever since the Second World War this has been a reliable signal that a recession is coming. The fears were compounded by the fact that the current cycle of expansion has been the third longest on record since at least the start of the 20th century, implying that it is high time for a recession.

However, whether the flattening yield curve signifies a recession hinges a lot on whether the long-term interest rates correctly reflect market participants’ expectations for the future path of the inflation and economic growth. Many observers have opined that huge capital is flowing from Europe and Japan into US treasuries in an attempt to avoid super low interest rate environment, thus distorting the long-end of the yield curve, making it flatter than it otherwise would have been.

This argument got a strong boost this week. The mere hint from Mario Draghi that Europe is moving away from deflation and a bit closer to reflation caused a sudden repricing of European debt. This spilled over to the US, where the 10-year treasury yield jumped from as low as 2.1% to 2.3% in a matter of days, showing that demand for US treasuries is indeed sensitive to the changing (expectations for) yields in Europe from super low to slightly higher and, by extension, depends on the capital inflow from the old Continent into the US.

In other words, there are very clear signs that the yields on US longer-dated treasuries have been kept artificially low because of foreign inflows and thus those yields did not accurately reflect market expectations for the future path of the US economic growth and long-term interest rates. It is therefore doubful that one can rely on the flattening yield curve as an indicator of an imminent recession. Investors in US equities can take a breath.

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