The yield differential between 10-year and 2-year Treasury notes is narrowing, and investors are fearful that a US recession would be around the corner if the curve were to invert. The spread has collapsed over the last few years, plunging to 0.3 per cent from 2.6 per cent, where it stood at the end of 2013. We anticipate an inversion in September, which is the next time the Federal Reserve is expected to raise rates.
The 2-year Treasury yield is heavily influenced by Fed policy. Since kicking off its tightening program in November 2015, America’s monetary authority has raised rates seven times, from 0.25 per cent to 2 per cent, and it is widely expected to hike two more times this year. The 10-year note, meanwhile, is tethered to the European Central Bank’s (ECB) unprecedentedly permissive monetary policy. The ECB has pledged to keep their zero-interest-rate policy in place until at least August 2019. Mario Draghi & Company are also maintaining their quantitative easing program and purchased more than $23 billion worth of bonds last month. As a result, the 10-year government bonds of France, Germany, Sweden and the Netherlands all yield less than 1 per cent, and Switzerland’s yield is below zero. That is what is keeping a lid on US 10-year rates.
Worried about the ominous implications of a yield curve inversion, President Trump attacked the Fed’s independence on Twitter recently, writing that he was “not happy” with the FOMC’s planned rate hikes. In our view, the President is not looking to control monetary policy but, rather, laying the groundwork for blame should the economy slow.
The yield curve is distorted and will likely not continue to be the reliable economic forecasting tool it once was, thanks to overbearing central bank influence. In fact, current economic conditions warrant higher interest rates both here and abroad. The Taylor Rule, an interest rate-setting algorithm that considers economic conditions, argues the Fed Funds rate should be more than double its current level; its European counterpart puts the ECB’s overnight interest rate at 3 per cent, not the current zero per cent. Our bottom line is that a yield curve inversion, were it to occur, would prompt ominous headlines but would not be a recession signal. Let’s get the central banks out of the bond markets. Yields are too low.