Fixed Income 101 tells us what this foreshadows: slowing economic growth.
More worrisome, when the two-year/10-year spread hits zero, or less (yield
curve inversion), that’s generally considered a slam-dunk for impending
recession. (See Figure 1)
So says the textbook. But today’s flattening curve doesn’t seem to jibe
with generally accepted wisdom about the state of the U.S., Canadian, or
global economy. BlackRock’s current models forecast steady, broad-based,
and above-trend global growth. More specifically, we see the U.S. economy
growing above trend and Canadian growth slowing, but only to trend.
Meanwhile, governments on this side of the Pond are talking fiscal stimulus
– tax reform in the United States, infrastructure spending here in Canada.
While the full impact of that planned spending is hard to gauge right now,
it could at least be mildly stimulative.
So are expectations for broad GDP growth overly optimistic? Or does the
robust global economy put the lie to textbook interpretations of the yield
curve? Is this once-reliable indicator “fake news”?
Well, we wouldn’t go that far, but we acknowledge that some unusual factors
are driving the curve flatter in the post-recession era, and they might not
signal slowdown or impending recession:
* Lower potential growth in this cycle, in which case the curve should be
flatter than in previous expansionary phases.
* Inflation expectations are low, justifying lower risk premia for long
* Canadian and U.S. central banks are in a hiking cycle, raising short-term
rates, which adds to the flattening.
* Monetary policymakers in Japan and Europe are still engaged in
quantitative easing, which is suppressing long yields and driving Japanese
and Euro bond investors elsewhere. That’s suppressing long yields in North
* The trend toward pension plan de-risking and insurance companies hedging
their long-date liabilities has created a huge demand for duration – which,
again, is flattening the curve.
And yet, against these perhaps-unique factors, the yield curve may still be
foreshadowing a slowdown. After all, the era of easy money is (probably)
coming to a close. The Fed has embarked on quantitative and monetary
tightening, and the ECB is sure to follow. That has negative implications
for growth, for both structural and historical reasons.
The structural factor is money growth (M2), which should slow as the Fed
reduces its balance sheet, and that could lead to a slowdown in bank
lending – which ultimately could lead to a slower economy. In a flattening
yield curve environment, monetary tightening would also put banks’ net
interest margin (NIM) under pressure, likely further dampening loan growth.
The historical factor is that in a tightening cycle, central banks
typically keep on raising rates until they get a negative reaction from the
economy. Sometimes, that ends up leading to a few hikes too many, tipping
the economy into recession.
So while we can see the extenuating circumstances creating a flatter yield
curve, we’re not quite ready to declare that it’s different this time. In
fact, we believe that the curve is telling investors to tread carefully and
be cautious, in particular, when it comes to risk asset allocation. As
Figure 2 shows, flatter yield curves tend to presage significant downturns
in equities– food for thought as North American indices continue to top
From a Canadian perspective, the degree of caution will depend on the
evolution of two factors in particular. One is the renegotiation of NAFTA:
Its abrogation or diminution will be disruptive to growth. Second,
Canadians’ high household debt balance has not gone away, and it has made
the economy more sensitive to interest rates in this cycle. Consumers have
binged on debt for the past eight years – at what point do higher rates
trigger a significant slowdown in consumption?
In short, while we expect broad-based growth, exogenous threats exist, as
do debt-fuelled risks that will not unwind easily. The flattening yield
curve suggests the economy is dancing on a knife’s edge between low and no/
negative growth. It might not take much to tip the balance, and the fall
could be painful, indeed.
Aubrey Basdeo, Managing Director, Head of Canadian Fixed Income, BlackRock, is a
member of the Product Strategy Team within BlackRock's Model-Based
Fixed Income Portfolio Management Group. He leads the product strategy
effort in Canada for both the Institutional and iShares businesses.
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article first appeared in the
BlackRock Canadian Fixed Income Portfolio Management Commentary Dec.
2017, on the BlackRock Canada website.
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