Since The Fed began its ‘tightening cycle’ in December 2015, the Treasury yield curve (2s10s) has flattened dramatically, tumbling back today towards cycle lows (and well below Trump-election-hope lows). What is perhaps more worrisome is the historical trend strongly suggests this trend is far from over and an inverted yield curve looms.
The trend is clear that Fed policy is running counter to growth expectations and all the hope that Trump offered has been erased completely.
But what happens next during a Fed tightening cycle? Citi explains…
US treasury markets, unsurprisingly, show a very clear trend towards higher front end-yields. On average longer end yields also ratchet higher, but by much less than at the short end, and with a lot more variability in the cycles. There is a clear trend towards curve flattening in other words.
Whilst this cycle is of course different in many ways (QE and bond scarcity, Fed balance sheet run down to start soon, etc.), we are still approximately in line with historic averages at the front end. At the long end, we are perhaps following the 2004 cycle a bit more, where 10y yields traded a range as the Fed hiked 17 times! Diversification into US govies by foreigners (Asia) played a big role back then, and this time round UST attractiveness to, especially yield starved, investors stands out. Low-flation is another reason why the longer end may display less beta as the Fed hikes this time.
With the historic analysis showing that 2s10s should flatten by at least a further 100 bp, we remain in curve flatteners in our macro portfolio alongside our tactical long in 10y USTs. Here, the recent breach of supports at 2.2% suggest we could move to 2.0% and we hold.
Which means that, given the current 85bps level of the 2s10s spread, 100bp more of flattening will mean an inverted curve, confirming the short-term recessionary fears many are feeling as US Macro Surprise Indices collapse…