With the US nearing full employment and wage pressure growing, expectations are rising that the Federal Reserve will raise interest rates as soon as this month.
Usually, an improving US economy that’s witnessing both a return to full employment and inflation nearing the Fed’s 2% target is accompanied by a steepening yield curve. The steepening yield-curve is technically explained as long-term yields rising more quickly than short term yields — because when things are looking good, and there’s lots of healthy opportunities for investment, investors demand more in return for tying up their capital for long periods.
But that’s not what’s going on this time around.
A quick look at the 2-year/10-year spread shows the yield curve has actually been tightening ever since the Fed began tapering its asset purchases at the end of 2013. In fact, the yield curve is down to 92 basis points and at its flattest level since 2007.
While this goes against textbook economics, Deutsche Bank’s chief international Economist Torsten Sløk says there’s a simple explanation for what’s taking place. He included this chart his monthly US Economic Outlook. The more red a country is, the higher percentage of its bonds have a negative yield.
Notice how the US isn’t on the chart. And that’s exactly the reason why the US yield curve is flattening. As money managers look around the world for yield they find there’s not a lot out there. Sløk told Business Insider:
The ongoing global hunt for yield is having a significant impact on US interest rates. Specifically, the US yield curve is distorted because of negative interest rates in Europe and Japan creating a significant inflow of money into US Treasuries, not driven by the outlook for the US economy and US inflation but driven by the weak outlook for growth in the rest of the world.
As the Fed continues to hike rates the yield curve is likely to flatten further as interest rate differentials with the rest of the world grow. This suggests an inverted yield curve may not signal a recession like it used to.
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