November Rates Update

Monthly Commentary

December 05, 2017

The holiday-shortened month of November failed to live up to the events of last November, which saw both a historic U.S. election result and a Chicago Cubs World Series win. Instead, this November saw 10y notes close the month 3bps away from where they opened as the yield curve continued its relentless march flatter. All told, the spread between the 2y and 10y points on the U.S. Treasury curve has flattened 61bps this year to reach 62bps, the flattest level since 2007. The flattening did not seem to disturb risk assets much though as U.S. equities continued their push higher, punctuated by a 1% rally in the S&P 500 and a 1.5% rally in the Dow Jones to close the month.

U.S. Treasury Market Overview

Source: Bloomberg

While the strong performance of U.S. equities would suggest smooth macroeconomic sailing ahead, there are some markets participants who are growing concerned with the ferocity with which 10y and 30y yields are converging on 2y and 5y yields. Historically, large flattening moves in the yield spread between the 2y and 10y that led to eventual curve inversion have proceeded all nine U.S. recessions since 1955. This phenomenon is usually observed because the Federal Reserve is tightening policy at the end of an expansion, pushing down future growth and inflation expectations, while moving the policy rate higher. This forces the spread between short rates and long rates tighter. The trend of curve flattening through rate hike cycles has been consistent. The 10y–2y U.S. Treasury yield spreads flattened meaningfully during each of the five prior rate hike cycles (’83-’84, ’86-’89, ’94-’95, ’99-’00, ’04-’06) and inverted the 2y–10y spread in three of the last five cycles. On average, the curve flattened by 110bps between first hike and last hike while the cumulative increase in the Fed funds target rate averaged 325bps. In this current rate hike cycle, we have experienced 65bps of flattening from where the 2y–10y spread sat at the start of December 2015 when the FOMC lifted off the zero-lower bound. Given how low outright 2y yields are versus past history, the hurdle for inversion is significantly higher now than in the past. It is notable that curve flattening isn’t a necessary precursor to recession outside the U.S., though the yield spread between 2y and 10y bonds in Japan has been positive since roughly 1990 and yet they have managed to have seven recessions since then.

Treasury Yield Spread vs. Oil Prices

Source: Bloomberg

During this most recent flattening trend in the Treasury curve, oil prices have done no favors for inflation, a key driver of curve steepness. This multi-year grind towards flatter yield curves has coincided with record lows in oil prices globally, so maybe this month’s decision from OPEC and non-OPEC participants to extend the production reduction agreements through year-end 2018 could be a catalyst towards steeper curves on net. However, for higher oil prices to have a meaningful impact on inflation they would probably have to stabilize at higher levels than current because the current backwardation in the oil futures curve still suggests market participants are not believers in the higher oil story at this juncture.

As U.S. policymakers continue to march the policy rate higher at a gradual pace, the BoE was simply happy to move their policy rate a mere 25bps higher and reverse the emergency post-Brexit rate cut at their November meeting. Unfortunately for the BoE, this tightening occurred into a substantially weaker economic backdrop than they could have hoped for. Although the unemployment rate is at its lowest in a generation, and the global outlook is looking more positive, household real income is barely growing and businesses have put investing plans on the back-burner as they wait for more clarity around Brexit. Usually, a central bank would not tighten policy amid so much economic and political uncertainty, but with inflation in the UK running well above 2% the BoE was forced to prove their willingness to tighten in the face of inflation. If this was indeed the initiation of a tightening cycle, market participants remain quite skeptical, only pricing in one 25bp tightening from the BoE through the end of 2018.

BOE Inflation Report Projections %, Modal Projection, Based on Market Rates

Source: BoE, J.P. Morgan
*BoE GDP forecasts are post-revision estimates

As the macro events of 2017 fade into the background and expectations for 2018 begin to take focus, it appears the overwhelming majority of market participants expect flatter U.S. yield curves, a weaker USD and lower prices in U.S. equities. While this trio of outcomes is certainly possible it seems to be more indicative of a lack of general overall consensus cross asset. For example, a lower USD could help push down U.S. export prices and support equities via corporate earnings suggesting simultaneous USD and U.S. equity weakness may be less likely than thought. Similarly, if the yield curve does indeed flatten in excess of notably flat forwards in 2018, it is probable this was driven by the FOMC tightening policy in excess of what is expected. That FOMC tightening should also be a bullish tailwind for the US as rate differentials are driven wider, making a base case of flatter curves and significantly weaker dollars harder to justify. That is not to say, we can’t see a flatter Treasury curve, lower equities and a lower USD in unison in 2018, macro markets make everyone look foolish at some point, but it will be fascinating to see how this dichotomy of calls unfolds in the next year.

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