To Citigroup Inc., the chances are slim that the U.S. enters a recession anytime soon. Officials at the Federal Reserve feel the same way.
Yet both camps agree that an inverted Treasuries yield curve would be an ominous sign for growth. And with the latest bout of flattening, the reality of sub-zero spreads may soon collide with an otherwise sanguine outlook on the economy.
The yield curve from 5 to 30 years has flattened to about 30 basis points, the narrowest spread since 2007. From 2 to 10 years, the gap of 42 basis points is also the smallest in more than a decade. For extending to 10 years from 7, investors pick up a mere 3.5 basis points, less than a quarter of what they got a year ago.
If the barrage of Fedspeak this week is any indication, the persistent flattening is creating a dilemma for officials, who appear intent on gradually tightening policy.
On the one hand, bond traders are finally starting to come around to officials’ path of hikes, with the unemployment rate the lowest since 2000 and inflation creeping higher. But stubbornly low long-term yields could eventually force the Fed to slow down, unless policy makers are willing to push the curve below zero.
Fed Sensitivity
“The Fed is going to be very sensitive to the shape of the yield curve,” said Katherine Renfrew, a portfolio manager at TIAA Investments, an affiliate of Nuveen. “If we get to the point where inversion might begin to happen, the Fed may put the brakes on further dialing back monetary stimulus.”
Something will have to give -- at least, if the Fed wants to keep investors from speculating that a recession is approaching. It took about six months for the curve from 5 to 30 years to flatten from around 30 basis points to zero in 2005-06. The curve from 2 to 10 years narrowed from about 40 basis points to zero in a similar amount of time. That puts both on track to invert by year-end.
“A potential curve inversion should be taken as seriously as always,” Citigroup analysts led by Jabaz Mathai wrote in an April 13 report. “The historical relationship between the curve and implied recession probabilities is highly non-linear: implied probabilities grow very fast when the curve moves into inverted territory.”
In the report, Mathai argued that the Fed is wrong on the yield curve, again. He noted that in 2006, then-Chairman Ben S. Bernanke said he didn’t see inversion as portending an economic slowdown.
Last month, current Chairman Jerome Powell said “there are good questions about what a flat yield curve or inverted yield curve does to intermediation.” Though he added: “I don’t think that recession probabilities are particularly high right now.”