There is a lot of focus in the press about the flattening of the US curve and what it means for the economic cycle.
In Chart 1 below I’ve included the yield differential between 30-year and 5-year US Treasuries over time, and marked recessionary periods in grey. You can see the differential falls – i.e. the curve flattens – into each recession.
The US 5/30s curve has been falling pretty relentlessly for some time. From 3% in November 2010 it has stayed below 2% since March 2014 and since September this year has fallen below 1% to around 70bps today. Does this mean we can expect a recession soon?
Chart 1 – US 5/30 curve and recessions
The fact that economic recessions have been preceded by a flattening of the yield curve is a pure mathematical reality. As the Federal Reserve increases rates it would be expected that eventually the average of the Fed funds rate will be higher in the short term, e.g. 2-year, than in the longer term, e.g. 10-year. A longer tenor will include not only the average of the current rate hike cycle, but also the likelihood of cuts in the future. The curve will be flat or inverted.
This however ignores the term premium associated with longer tenors. A rational investor not only would demand the average of future base rates but also a premium to compensate for the risk of default, high inflation or lack of fiscal frugality. This term premium varies over time, but currently it is low or negative (a discussion for another day).
In order to determine the impact that central bank policy will have on economic activity, it is essential to understand the ‘neutral’ level of rates. To the extent that the Fed funds rate is still below the neutral rate (that is the level of interest rates that makes the desire to save and invest equal), higher rates are only a removal of accommodation, not a tightening of monetary policy. Therefore the economy will continue growing above the level of potential. It would be only when rates overshoot this neutral rate that we should see a slowdown in activity and eventually higher unemployment.
In the current economic cycle (now lasting over 100 months – the second longest in history) we will eventually get there, but it is not a short-term risk. US financial conditions are looser than when the Fed started hiking in 2015 (as shown in Chart 2 below). Funding costs for corporates are lower, long-term mortgages are not far off their lows, the trade-weighted dollar has depreciated and equities are not far off all-time highs. In other words, the economy has not really felt higher borrowing costs and therefore should continue growing strongly, supported by favourable domestic (including looser fiscal policy) and global dynamics.
Chart 2 – Federal funds rate versus financial conditions index
Source: Bloomberg, Goldman Sachs US Financial conditions index. Fed funds is Federal Funds Target Rate – Upper Bound.
To conclude, statistically a recession is getting closer, it would be silly to assume that the current economic cycle will last forever (indeed it may be that 2017 was as good as it gets for the global economy), but in the short term, irrespective of the flattening of the curve, it is hard to see a meaningful risk of recession.