This familiar warning signal from the bond market will be worth watching in 2018

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Tightening yield spreads in Australian and US government debt have been a key theme for bond traders this year.

A narrowing yield spread — also described as a flatter yield curve — is a measure of the gap between short-term and long-term interest rates.

It’s important because historically, narrowing spreads have acted as a key indicator that economic growth is slowing.

This chart shows how the yield spread between 2-year and 10-government debt has narrowed in 2017, for both the US and Australian bond markets:

Australian government bonds have rallied across the curve this week, with yields declining on both shorter and long-term debt.

But over the past month, there have been steeper declines in the yield on longer term 10-year bonds. As a result, spreads on Australian 10-year debt and shorter-term 2-year bonds have narrowed by around 20 basis points.

The decline in 10-year bond yields has coincided with a reduced inflation outlook by the RBA. The bank downgraded its medium-term inflation forecast in the quarterly Statement on Monetary Policy two weeks ago.

That leaves the current yield spread at around 75 basis points — back near its June lows, having declined by almost 40 basis points from the 2017 high reached in February.

The flattening of the 2-10 yield curve in US government debt this year has been steeper.

It’s halved from a high of above 120 basis points to the current spread of around 60 basis points — the lowest in a decade.

That’s been driven by a sharper rise in shorter-term 2-year yields, as the US Fed remains on track to raise rates next month but the outlook for further rate hikes next year is looking increasingly unclear.

A narrowing yield curve in US government debt has been a good predictor of recessionary conditions in the US economy.

Since 1977, every time the US yield spread has inverted — meaning it will cost more to borrow for the short-term than the long-term — a recession has followed.

However, once bond yields invert the timing of the next recession is hard to predict. It could be anywhere from the following year to three years after the inversion:

So what impact will the recent moves in bonds have on other asset classes?

Oliver Jones from Capital Economics doesn’t believe that a downturn in US stocks is forthcoming — at least in the near term.

Jones said the backdrop of relatively strong economic growth should provide support for the S&P500, even if the yield spread on US bonds continues to narrow.

“Large and sustained falls in the S&P500 have not occurred until growth in the US economy has actually begun to falter,” Jones said.

“And this has tended not to happen until after the yield curve has become inverted and is starting to steepen again.”

Source: Capital Economics

As a result, Capital Economics are forecasting US stocks to finish slightly lower next year before steeper falls in 2019.

While the yield spreads on Australian and US debt both still have further to fall before they invert, this year’s moves are representative of an increasingly cautious economic outlook in credit markets this year.

It’s perhaps reflective of the interesting challenges facing developed economies in 2018, amid the backdrop of steady economic growth and stubbornly low inflation.

How Australia’s economy navigates the threat to domestic consumption as household cash flows tighten is likely to at least partly determine whether the yield spread continues to tighten.

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