Is It Still A Yield Curve When It’s Flat?

What’s flattest: Kansas, a pancake, or the US Treasury yield curve? Between the first two, the flapjack actually loses out to Dorothy Gale’s (Wizard of Oz) home state. Back in 2003, geographers measured the contours of an IHOP pancake with a laser microscope and compared those to a topographical map of Kansas. The pancake had much more surface variation. Kansan geographers defended their home turf a few years later, pointing out that Florida was actually flatter than Kansas. But both are still flatter than a pancake.

Don’t count the Treasury yield curve out of this race just yet, however. At a difference today of just 55 basis points between 2 Year and 10 Year Treasuries yields, it is as flat as it was in August-September 2007 (and you know what happened then…). The recent inflation scare did push it to 78 basis points in early February, but it is now closing in on the lows from January (50 basis points).

Earlier this month the San Francisco Fed published a fresh paper on this timeworn indicator that reminds us all why this matters so much. Simply put, when the Treasury yield curve inverts (2 Years yield more than 10s), recession almost always follows. And, of course, before it inverts it goes flat. Like a pancake.

A few sound bites from the paper and our observations:

“Every US recession in the past 60 years was preceded by a negative term spread.”
Translation: there aren’t many economic indicators that work every time. This is one of those rare few. Pay attention to it.

“…the power of the term spread to predict economic slowdowns appears intact.”
Translation: nothing is different this time.

“While the current environment appears unique compared with recent economic history, statistical evidence suggests that the signal in the term spread is not diminished.”
Translation: we’ve read all the commentary that central bank easing in Europe and Japan has artificially lowered long term interest rates so the shape of the US Treasury yield curve is an anomaly. We aren’t buying it.

With such a clear-eyed analysis, the SF Fed paper seems to be a warning shot to the Federal Open Market Committee about the perils of increasing Fed Funds so quickly that markets anticipate a day when they exceed 10 Year Treasury yields. Fed funds rates, after all, inform Treasury bill yields which in turn dictate the short end of the yield curve. Will the FOMC and new Chair Jay Powell go against the historical evidence and signal a pathway to +3% Fed Funds when 10 year Treasuries yield less? Probably not.

The key number markets seem to be watching is the breakeven rate between inflation-protected Treasuries (TIPS) and their plain vanilla fixed-principal counterparts. The differential points to expected future inflation and, therefore, the structural level of long term interest rates. Two data points here:

Both have been rising over the past year but seem stalled at current levels – right around 2%. Yes, right at the Federal Reserve’s target for consumer inflation. How these develop through the year will inform market perceptions of Fed policy in 2H 2018 and beyond. It is a fine balance, both for the Fed and markets. But every balance has a fulcrum, and inflation expectations are that wedge.

San Francisco Fed Paper:

Graph of 2-10 Treasury Spreads back to 1976 (St. Louis Fed):