What causes the yield curve to flatten?

Confluence Investment Management offers various asset allocation products which are managed using top down or macro analysis. We publish thoughts on asset allocation on a weekly basis in this report, updating the report every Friday, with coaching Podcast.

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A note to readers: The Asset Allocation Weekly will be on hiatus during the holidays following today’s report and will return as a bi-monthly publication, now Monday, starting January 10, 2022. From us all at Confluence Investment Management, we wish you a Merry Christmas and Happy New Year! See you in 2022! Bond yields – and the relationship between them – may be among the most important economic and financial indicators an investor can watch, and today’s yields tell an important story.

The “yield curve,” which represents market returns by maturity, has recently flattened as the difference between long-term and short-term returns has narrowed. This is the first time that such a flattening has occurred in nearly five years, which is why this article takes a close look at what this flattening tells us about the future of the economy.

A full yield curve would plot the yields for all maturities at any one time. A quick summary of the yield curve and how it will move is provided by simply plotting the yield on the 10-year T-bill minus the yield on the 2-year T-bill over time as shown in the chart below. Over the past two decades, the yield on the 10-year Treasury has generally been 1.35% higher than that on the 2-year Treasury. When the economy is recovering from a recession or starting to accelerate, investors often anticipate higher inflation and better equity opportunities in the future, so they buy fewer long-term bonds. . This lowers their prices and increases their yields relative to shorter-term bonds. The yield curve then steepens. As shown in the graph below, this is exactly what happened in the year after the coronavirus pandemic first hit the US economy in early 2020. In the spring of 2021, the difference between the 10-year Treasury yield and the 2-year Treasury yield widened to 1.47%, exceeding its 20-year average for the first time in half a decade.

More recently, however, the yield curve has started to flatten again. The 10-year rate is currently only 0.80% above the 2-year rate. What explains this dramatic turnaround? We believe it reflects two closely related expectations of investors. First, price inflation has worsened throughout 2021 and shows no signs of being as fleeting or “transient” as Fed policymakers had anticipated. Investors correctly guessed that persistent inflation would prompt the Fed to tighten monetary policy sooner than initially expected. Last month, the Fed started cutting its bond purchases, and recently signaled that it would soon accelerate its reduction enough to stop all bond purchases by early 2022. That would position the Fed for start raising its benchmark short-term interest rate in the first half of the year. 2022. Buying enthusiasm for short-term bonds consequently weakened, pushing up their yields. This can be seen clearly in the sharp increase in yields on 2-year Treasuries (see green line in chart below).

Equally important, we believe the market action shows that investors have also taken a more pessimistic view of long-term economic performance. Investors seem to expect sluggish growth to return, perhaps because they believe the Fed will tighten monetary policy too sharply in the coming months. Not only have short-term yields surged, but the chart shows that long-term yields have peaked well below their usual level during the previous expansion (see the red line in the chart above). In fact, the yield on the 10-year Treasury bill is currently below its minimum level from 2008 to 2019. Bond yields are expected to be this low over the next year.
decade implies an expectation of very low economic growth and low inflation.

What could cause such a result? This could be the result of the global economy returning to its pre-pandemic state, in which growth and inflation were brought under control by strong structural headwinds, such as slowing birth rates, population aging, gender inequalities. high incomes, excessive debt, expanding globalization and new technologies. However, some of these headwinds, like globalization, appear to be receding. We believe that much of the cap on long-term yields reflects investor fear that the Fed is tightening monetary policy too much. Such a policy mistake by the Fed could bypass the nascent economic expansion and produce another recession, especially since much of the federal government’s fiscal stimulus in the event of a pandemic will be removed in the next few months. year. For the short-term asset allocation strategy, any further flattening of the yield curve would therefore suggest greater caution with regard to risky assets.


Past performance is no guarantee of future results. The information provided in this report is for educational and illustrative purposes only and should not be construed as individualized investment advice or a recommendation. The investment or strategy discussed may not be suitable for all investors. Investors must make their own decisions based on their specific investment objectives and financial situation. The opinions expressed are current as of the date indicated and are subject to change.

This report was prepared by Confluence Investment Management LLC and reflects the current opinion of the authors. It is based on sources and data believed to be accurate and reliable. The opinions and forward-looking statements expressed are subject to change. This is not a solicitation or an offer to buy or sell securities.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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