BAML says a flattening US yield curve won't stop the Fed from hiking rates

Photo: Paul Gilham/ Getty.
  • The US yield curve — the difference between short and longer-dated bond yields — is flattening fast.
  • In the past, this almost always signals that a recession is coming.
  • BAML says that despite the risks, the Fed will continue to hike interest rates over the next couple of years.

The US yield curve is flattening, a normal part of the economic cycle as the US Federal Reserve continues to lift interest rates.

However, as the difference between short and longer-dated bond yields continues to narrow, there’s an growing unease among some in financial markets about what it may be signalling.

In other economic cycles, when the curve has flattened, and then eventually turned negative, it’s almost always signalled that a recession is coming.

Source: BAML

Why would this time be any different, right?

Given the Fed is a major contributing factor to this flattening, some believe it should slow or stop lifting interest rates to prevent a possible economic downturn.

Bank of America Merrill Lynch (BAML) doesn’t share that view, suggesting in a note this week that the Fed shouldn’t and won’t stop lifting rates over the next couple of years.

“The 2-year-10-year slope is down to 43-44 basis points, the flattest since September 2007. This has led some commentators to argue that the Fed should slow the pace of rate hikes in order to avoid inverting the curve. We push back against this argument,” it says.

BAML says even though the Fed will likely lift interest rates five more times before the end of 2019, it doesn’t see the US yield curve inverting in the near-term.

“If economic fundamentals are supportive of steady Fed tightening, they will probably also be supportive of at least a modestly higher 10-year yield,” it says.

And when the yield curve eventually inverts, something that BAML expects, it says there’s no guarantee that an impeding recession will follow soon after.

“We think the yield curve will eventually invert. And history suggests that there can be a lag of several quarters between yield curve inversion and recession,” it says.

“Moreover, the yield curve has become relatively flat in recent years as the ‘term premium’ is now close to zero—inversions are no longer extraordinary events.”

As such, it doesn’t expect the Fed to get spooked by the recession talk.

“For now we expect the Fed to continue to hit the snooze bar when it comes to a flattening curve,” it says.

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