• The US yield curve is flattening, driven by ongoing rate hikes from the US Federal Reserve.
• The current spread between US 2 and 10-year bond yields is around 40 basis points, and could turn negative in the not-too-distant future. When this has occurred in the past, it’s almost always signalled that a recession will soon follow.
• Westpac has evaluated whether the signals from US yield curve have been altered by QE from major central banks.

The US yield curve is flattening, driven by ongoing rate hikes from the US Federal Reserve.

The current spread, or difference, between US 2 and 10-year bond yields is now around 40 basis points, more than 200 basis points below the level it sat in early 2014.

As the Fed continues to lift its funds rate, the differential between short and longer-dated US bond yields is expected to narrow further, and potentially turn negative.

In the past, that’s almost always signaled that a US recession is just around the corner.

So understandably, it has some people nervous.

However, in an era where major central banks are still supporting economic growth with vast asset purchase programs — more commonly known as “QE” — is the flattening of the US yield curve really suggesting that a recession is imminent?

For want of a better way to put it, this era of global monetary policy settings, as opposed to prior periods when the US yield curve has been flattening, is different.

Central banks such as the European Central Bank and Bank of Japan are still buying tens of billions in government bonds each and every month, sending capital into other markets, including US treasuries.

It begs the question as to what the US yield curve would look like if QE wasn’t being implemented.

Would it be anywhere near as flat as it currently is? And, more importantly, would it be signalling a US economic downturn is approaching?

To answer those questions, David Goodman, Head of Macro Strategy at Westpac Bank, has attempted to show what the spread between US two and 10-year bond yields would look like without the impact of QE.

Using the modelling conducted by the Fed on the effect of QE on the term premium (TP) for US treasuries, the excess return investors demand for holding a longer-term bond as opposed to a shorter-dated equivalent, Goodman presents the chart below showing what the current spread may look like.

While a hypothetical scenario, with term premium not the only consideration in determining bond yields, Goodman says the current spread would likely be significantly wider without the effect of QE.

“[It] shows that the curve is currently some 80 basis points flatter than otherwise — for example, around 120 basis points rather than the current 40 basis points and looking further from a threatening recession signal than a simple examination of the nominal curve suggests,” he says.

“[The] US curve shape has done a commendable job of predicting growth outcomes, with a curve inversion a clear warning.

“However, with QE suppressing yields, do these relationships still hold and does the curve contain the same information it once did?,” Goodman asks.

While no one knows that answer for sure given the unique period of monetary policy we’re now only starting to exit, it does suggest a degree of caution is warranted about the current signals being generated by the US yield curve.

With speculation building that the ECB may soon announce an end date for its asset purchase program, cutting off a source of liquidity that has helped to support asset prices, we may be about to get a clearer picture on what the medium-to-long term future holds.

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