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Flattening Treasury Yield Differential Raises Questions About the Health of US Economy
Moneylife Digital Team 03 January 2018
Economy & Nation
The difference in the yields of 2-year and 10-year US Treasury (UST) securities have flattened. This has raised concerns signalling low-confidence in the short term health of the US economy, according to DBS bank’s Philip Wee and Eugene Leow.
 
Investors lock-in their money in long-term securities if there is a higher interest rate being offered for the risk of being invested for so long, and vice-versa for short-term securities. But what is happening right now is the opposite. This relentless flattening of the 2Y/10Y segment of the UST curve signals that investors are okay with fixing on a meagre 50-60 bps (basis points) difference on long-term securities over its short-term counterparts. Usually, this difference is of above 100 bps. A single basis point is 1/100th of a percent.
 
Such an inverted yield curve has often historically been a harbinger of an economic recession. Investors are willing to accept a lower interest rate now in return for being locked in for years to come.
 
 
It is clear that the Fed has a hawkish stance on its monetary policy, continuing in 2018 as well. The further increase in the fed rates will curb growth levels, as it will affect credit purchases and increase the cost for businesses looking to finance new and older projects. An increase in financing costs of new projects and the older ones, which will lead to reduced profits, will nudge companies to downsize and lay-off employees.
 
This will be the first indicator in the deflation-recession phase, which is what the bond traders are worried of. This is why investors have flogged to long-tenure securities, with best performing tenor last year being the 30Y, whose yields fell by 33bps while 10Y yields ended the year down by 3bps. Comparatively, 2Y yields rose by 69bps over the same period.
 
So even if the yield on the 30-year securities is a meagre 2.8%, the real-rate will be high as inflation will continue to be low; really low.
 
According to Bloombergview article, there is another factor pinning down longer-term yields: forced buyers, both in the U.S. and elsewhere.
 
Asset-liability managers like insurance companies and pension funds are always seeking duration, and 30-year Treasuries are among the best ways to get it. Combine that appetite with increased demand from passive mutual fund giants, the European Central Bank and you’ve got a recipe for a sustained bid on the long end of the Treasury curve.
 
If that wasn’t enough, Treasury recently announced that it wants to focus increased issuance in bills and shorter-dated coupon maturities, like two- and five-year notes. The fresh issuance of short-term bills has far exceeded issuances of long-term bonds in 2017, and will continue in this year as well. This scarcity on the long-term end has forced the yields down, flattening the yield differences.
 
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