The US yield curve has flattened, giving rise to comments that, given the historical experience, risk of a recession is increasing. Yet, when drawing conclusions, caution is warranted. Market-based inflation expectations, which are very high, should decline after a number of rate hikes. This could pull down long-term nominal bond yields, leading to a further flattening or even an inversion of the curve. However, a decline in inflation is growth-supportive. Another reason for caution is that due to past central bank asset purchases, the slope of the yield curve is less steep. Past QE may thus reduce its quality as a leading indicator of economic growth. For these reasons, an alternative indicator has been developed. The near-term forward spread compares market-based expectations for short-term interest rates in 18 months’ time with current short-term rates. Its record as leading indicator is better and, what’s more, the current spread is very large. This implies that we should not yet be concerned about the flattening of the yield curve.
When looking at the US yield curve, there is a déjà vu feeling. The curve has flattened significantly in recent weeks and media articles have quickly followed, explaining what this may signal about recession risk.
Such a reaction makes sense on theoretical grounds. Yields on long-dated bonds predominantly reflect longer-term expectations about short-term interest rates, which depend on monetary policy expectations, as well as a term premium1. A steep yield curve reflects an accommodative monetary policy stance with central bank rates well below their long-term expected values. A flattening of the curve implies a reduction of monetary support and may trigger a downward revision of the growth outlook. This revision will be more outspoken when the curve inverts. In that case, short-term rates are above their long-term expected value, policy is tight and is expected to be eased at some point because growth and inflation will have declined.
The theoretical argument may be compelling but the empirical evidence is an even stronger underpinning for the reaction of journalists and analysts alike. Such is the perceived quality of an inversion of the curve as a leading indicator of recession, that a mere flattening already gives rise to concern, based on the view that it is only a matter of time until an inversion will follow. Yet, caution is warranted in assuming that these stylised facts still apply as much today as they did in the past
One reason is that at present, market-based inflation expectations are very high because investors are concerned that inflation may continue surprising to the upside. When this view changes, break-even inflation – the difference between the yield on a nominal bond and the yield on an inflation-linked bond of the same maturity – will decline, pulling down, ceteris paribus, nominal bond yields at longer maturities. What follows in that case is a further flattening or even an inversion of the yield curve. However, such a development would reduce the risk of recession, rather than increasing it: a decline in inflation is growth-supportive because it raises households’ purchasing power. Moreover, the Federal Reserve could afford to tighten less than initially envisaged. Another reason for caution is the influence of the Fed’s balance sheet on the level of Treasury yields. Central bank asset purchases aim to influence long-term bond yields by lowering the term premium, so the slope of the yield curve should be less steep than in a world without QE. This may reduce its quality as a leading indicator of economic growth.
Assessing the growth outlook through the lens of the slope of the yield curve boils down to gauging whether monetary policy is growth supportive or a threat to growth. This provides an argument for looking at the shorter end of the yield curve.
Its greater cyclical amplitude compared to the long end of the curve implies it is more sensitive to changes in the growth and inflation outlook. Hence its signal quality may be better. This is the approach followed by the Federal Reserve in a research note of 20182. However, the comparison of a two or three year yield with the short-term interest rate could still be influenced by the term premium.
To avoid this, the authors calculate the near-term forward spread, i.e. the difference between the implied interest rate on 3-month Treasury bills in 18 months’ time with the current 3-month rate3. This is then used to calculate the probability of a recession over the next four quarters4. It turns out that the near-term forward spread is highly significant and that the long-term spread – the 10-year yield minus the 2-year yield –, when added to the equation, is not significant. The accompanying chart has been inspired by this approach although for data availability reasons, libor rates (spot and forward) have been used to calculate the near-term forward spread5. As shown by the chart, recessions have been preceded by an inversion of this spread in combination with a flat or even inverted yield curve. At the current juncture, the yield curve has flattened very significantly but the near-term forward spread is very high.
The opposing signals, in combination with better quality of the forward spread as leading indicator, imply that we should not yet be concerned about the flattening of the yield curve. There is an important caveat however. The huge near-term forward spread reflects market expectations of significant monetary tightening over the next several quarters. If the FOMC proceeds as expected, this could end up pushing down long-dated bond yields and trigger a yield curve inversion. In addition to the discomfort this would create, aggressive tightening could also suddenly change the monetary policy outlook, causing a decline of the near-term forward spread. In such an environment, recession fears would inevitably increase.
BNP Paribas is regulated by the FSA for the conduct of its designated investment business in the UK and is a member of the London Stock Exchange. The information and opinions contained in this report have been obtained from public sources believed to be reliable, but no representation or warranty, express or implied, is made that such information is accurate or complete and it should not be relied upon as such. This report does not constitute a prospectus or other offering document or an offer or solicitation to buy any securities or other investment. Information and opinions contained in the report are published for the assistance of recipients, but are not to be relied upon as authoritative or taken in substitution for the exercise of judgement by any recipient, they are subject to change without notice and not intended to provide the sole basis of any evaluation of the instruments discussed herein. Any reference to past performance should not be taken as an indication of future performance. No BNP Paribas Group Company accepts any liability whatsoever for any direct or consequential loss arising from any use of material contained in this report. All estimates and opinions included in this report constitute our judgements as of the date of this report. BNP Paribas and their affiliates ("collectively "BNP Paribas") may make a market in, or may, as principal or agent, buy or sell securities of the issuers mentioned in this report or derivatives thereon. BNP Paribas may have a financial interest in the issuers mentioned in this report, including a long or short position in their securities, and or options, futures or other derivative instruments based thereon. BNP Paribas, including its officers and employees may serve or have served as an officer, director or in an advisory capacity for any issuer mentioned in this report. BNP Paribas may, from time to time, solicit, perform or have performed investment banking, underwriting or other services (including acting as adviser, manager, underwriter or lender) within the last 12 months for any issuer referred to in this report. BNP Paribas, may to the extent permitted by law, have acted upon or used the information contained herein, or the research or analysis on which it was based, before its publication. BNP Paribas may receive or intend to seek compensation for investment banking services in the next three months from an issuer mentioned in this report. Any issuer mentioned in this report may have been provided with sections of this report prior to its publication in order to verify its factual accuracy. This report was produced by a BNP Paribas Group Company. This report is for the use of intended recipients and may not be reproduced (in whole or in part) or delivered or transmitted to any other person without the prior written consent of BNP Paribas. By accepting this document you agree to be bound by the foregoing limitations. Analyst Certification Each analyst responsible for the preparation of this report certifies that (i) all views expressed in this report accurately reflect the analyst's personal views about any and all of the issuers and securities named in this report, and (ii) no part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed herein. United States: This report is being distributed to US persons by BNP Paribas Securities Corp., or by a subsidiary or affiliate of BNP Paribas that is not registered as a US broker-dealer, to US major institutional investors only. BNP Paribas Securities Corp., a subsidiary of BNP Paribas, is a broker-dealer registered with the Securities and Exchange Commission and is a member of the National Association of Securities Dealers, Inc. BNP Paribas Securities Corp. accepts responsibility for the content of a report prepared by another non-US affiliate only when distributed to US persons by BNP Paribas Securities Corp. United Kingdom: This report has been approved for publication in the United Kingdom by BNP Paribas London Branch, a branch of BNP Paribas whose head office is in Paris, France. BNP Paribas London Branch is regulated by the Financial Services Authority ("FSA") for the conduct of its designated investment business in the United Kingdom and is a member of the London Stock Exchange. This report is prepared for professional investors and is not intended for Private Customers in the United Kingdom as defined in FSA rules and should not be passed on to any such persons. Japan: This report is being distributed to Japanese based firms by BNP Paribas Securities (Japan) Limited, Tokyo Branch, or by a subsidiary or affiliate of BNP Paribas not registered as a financial instruments firm in Japan, to certain financial institutions permitted by regulation. BNP Paribas Securities (Japan) Limited, Tokyo Branch, a subsidiary of BNP Paribas, is a financial instruments firm registered according to the Financial Instruments and Exchange Law of Japan and a member of the Japan Securities Dealers Association. BNP Paribas Securities (Japan) Limited, Tokyo Branch accepts responsibility for the content of a report prepared by another non-Japan affiliate only when distributed to Japanese based firms by BNP Paribas Securities (Japan) Limited, Tokyo Branch. Hong Kong: This report is being distributed in Hong Kong by BNP Paribas Hong Kong Branch, a branch of BNP Paribas whose head office is in Paris, France. BNP Paribas Hong Kong Branch is regulated as a Licensed Bank by the Hong Kong Monetary Authority and is deemed as a Registered Institution by the Securities and Futures Commission for the conduct of Advising on Securities [Regulated Activity Type 4] under the Securities and Futures Ordinance Transitional Arrangements. Singapore: This report is being distributed in Singapore by BNP Paribas Singapore Branch, a branch of BNP Paribas whose head office is in Paris, France. BNP Paribas Singapore is a licensed bank regulated by the Monetary Authority of Singapore is exempted from holding the required licenses to conduct regulated activities and provide financial advisory services under the Securities and Futures Act and the Financial Advisors Act. © BNP Paribas (2011). All rights reserved.
Recommended Content
Editors’ Picks
![EUR/USD holds near 1.1100, looks to post small weekly gains](https://editorial.fxstreet.com/images/Markets/Currencies/Majors/EURUSD/money-9377516_XtraSmall.jpg)
EUR/USD holds near 1.1100, looks to post small weekly gains
EUR/USD trades near 1.1100 in the American session on Friday. Although the risk-averse market atmosphere caps the pair's upside, dovish comments from Fed officials and the disappointing US jobs report help it hold its ground.
![GBP/USD retreats to 1.3150 area after post-NFP spike](https://editorial.fxstreet.com/images/Markets/Currencies/Majors/GBPUSD/iStock-1178148633_XtraSmall.jpg)
GBP/USD retreats to 1.3150 area after post-NFP spike
GBP/USD turns south and declines to 1.3150 area after spiking to 1.3240 in the early American session. The negative shift seen in risk mood following the US labor market data for August helps the US Dollar stay resilient against its peers and weighs on the pair.
![Gold pulls away from near record highs, holds above $2,500](https://editorial.fxstreet.com/images/Markets/Commodities/Metals/Gold/Gold_Bar_XAU_Precious_Metal_XtraSmall.jpg)
Gold pulls away from near record highs, holds above $2,500
Gold came within a touching distance of a new all-time high near $2,530 as US Treasury bond yields turned south on disappointing US jobs data. The US Dollar's resilience amid a souring risk mood, however, caused XAU/USD to erase its daily gains.
![Crypto today: Bitcoin, Ethereum, XRP tests key support, TRON network non-stablecoin activity hits new highs](https://editorial.fxstreet.com/images/Markets/Currencies/Digital%20Currencies/Bitcoin/bitcoins-37949586_XtraSmall.jpg)
Crypto today: Bitcoin, Ethereum, XRP tests key support, TRON network non-stablecoin activity hits new highs
Bitcoin, Ethereum, and XRP hover around key support levels after registering a steep correction earlier this week. TRON network’s stablecoin activity hit new highs following the release of SunPump.
![Nonfarm Payrolls expected to show modest hiring rebound in August after July’s tepid report](https://editorial.fxstreet.com/images/Macroeconomics/EconomicIndicator/Employment/NFP/us-job-hunter-8793311_XtraSmall.jpg)
Nonfarm Payrolls expected to show modest hiring rebound in August after July’s tepid report
The Nonfarm Payrolls report is forecast to show that the US economy added 160,000 jobs in August, after creating 114,000 in July. The Unemployment Rate is likely to dip to 4.2% in the same period from July’s 4.3% reading.
![Moneta Markets review 2024: All you need to know](https://editorial.fxstreet.com/images/IT/Testing/Review/FXSBadgeCertifiedBackg_XtraSmall.png)
Moneta Markets review 2024: All you need to know
VERIFIED In this review, the FXStreet team provides an independent and thorough analysis based on direct testing and real experiences with Moneta Markets – an excellent broker for novice to intermediate forex traders who want to broaden their knowledge base.