As the U.S. Treasury yield curve has flattened over the last year and more particularly since the third quarter of 2017, many have wondered aloud if this development reflected a greater likelihood for a forthcoming recession. It’s been said that while recessions generally follow an inverted yield curve, not every instance of an inverted yield curve has been followed by a recession. And so, this is where many minds have gone – what will it mean when the yield curve inverts…rather than will the yield curve invert anytime soon.
When we look to the Treasury 5-year/30-yield spread, which is currently at 46 basis points wide and clearly within a fairly well defined flattening trend, we can understand why there might be little interest in positioning against additional flattening. Powerful trends, especially those where momentum has shown to more recently accelerate are rarely the low lying fruit sought by position takers. However, much longer-term momentum guidelines may benefit our examination and provide, if nothing else, a technical reason to consider yield spread stabilization prior to a zero spread breach.
In September of 1981, the 30-year U.S. Treasury yielded over 15% and lately, numerous assertions have been made that the three-plus decade slide in Treasury long bond yields come to an end. I’ll not argue this. Instead, I can find little but strong evidence that higher bond yields are forthcoming. They include, but are not limited to growth at or above current longer run potential, likely forthcoming global central bank quantitative tightening and latent inflationary impulses. What concerns me is that much of my concerns for higher bond yields are widely held and likely already priced to a greater or lesser extent.
As for the yield spread; late in the third quarter of 1981, the U.S. Treasury 30-year yield was climbing slightly above 15% while the yield on the five-year managed to similarly exceed 16%. In August of 1981 as these high yields were being approached the yield difference fell briefly to a negative 1.5% before quickly rebounding. For 36 years, that has stood as the largest negative spread. The Treasury 5-year/30-yield spread has widened somewhat evenly to just a hair over 3% in November of 2010.
Please review the chart below and notice the compelling channel that has captured this yield spread since the early 80s. The lower trend line comes in at 32 bps today and the slope of this line is so modest that it does not exceed 33 bps until mid-April. It is easy enough to imagine that, if not already, any further compression of this yield spread over the coming weeks might lead to strong majority expecting a more immediate return to a negative yield curve.
Without getting too distracted by technical conditions, please consider also that rarely has the RSI or Stochastic levels fallen as low as they currently are without signaling a bottom.
Continued scheduled reduction of the Fed’s balance sheet could start to reduce rather accommodative financial conditions leaving the Fed to back away from widely expected (SEP dot matrix) three rate hikes in 2018. A negative shock to the equity market might be seen despite a growing majority of pundits expressing another bullish 2018, though few of the same had envisioned a robust 2017. Such a shock would likely pare expectations for continued immediate Fed tightening. Finally, simply strong economic growth or some renewal of inflationary pressure would result in higher bond yields. These and many other possibilities exist which could cause the US Treasury yield curve to widen.