New research from ETF Securities argues that the shape of the US yield curve indicates the US economy could be approaching a peak. The yield curve has been flattening since 2009 and Morgane Delledonne, fixed income strategist at ETF Securities, thinks it is approaching levels that indicate the US business cycle might be nearing a turning point.
Morgane Delledonne, assistant director – fixed income strategist, ETF Securities.
“The US unemployment rate is now close to its pre-crisis and structural level of 4.6% while the US economy is growing close to its potential growth rate of 2% annually. This combined with the flattening of the US Treasury yield curve both suggest the US economy is approaching a peak.
“A steep curve generally coincides with a high unemployment rate and strong economic growth. The US Treasury steepness spreads has been falling for the past five with the market’s anticipation of monetary tightening. The steepness spread (the difference between 10-year and 3-month US treasuries) currently stands at 160bps but we expect it will compress further until becoming negative as the Fed gradually increase interest rates.”
Source: ETF Securities.
The research also finds that the duration or term premium on bonds can be indicative of position in the economic cycle. Long-term bond yields are a function of two unobservable components, the expected average of short-term rates and the term premium. The term premium is the compensation investors receive for giving up current consumption to invest in uncertain long-term yields. Investors require a higher term premium when the economy is near a cycle trough and the yield curve is steep. On the contrary, investors accept low or negative premiums when the economy is near a peak and the yield curve is flat or inverted.
Source: ETF Securities.
As the graph above shows, the term premium has been on a downward trend since 2009 and has even turned negative according to some estimates.
Delledonne said, “The demand for long-term bonds over the past decade has been growing due to structural, regulatory and cyclical factors. In particular, the large-scale asset purchase programmes conducted by major central banks have led to government bonds becoming scarce and have pushed yields lower. The combined effect of the global “saving glut” and stricter regulations also partly explain why the yield curve is typically flat or inverted at long maturities. Investors are willing to accept negative term premiums to comply with their liabilities or regulatory constraints.”
Delledonne concludes, “Our reading of the US economic data and US treasury yield curve suggest the US economy is approaching a peak. With the US stock market at all-time highs and with a low inflation rate, investors accept negative term premium as a price for hedging against stocks and recession. The current negative relationship between US government bonds and US stocks reinforces this view as US government bonds exhibit diversification properties.”