US yield curve inversion now likely unless the Fed changes its rhetoric

Althea Spinozzi

Fixed Income Specialist, Saxo Bank Group

After spending the past week anxiously waiting to see how the US president played the G7 meeting and North Korea summit, it is clear that Trump himself embodies the biggest risk that could push the largest economy in the world into a recession again, just 10 years after the financial crisis.

This may sound odd, especially in light of the apparent US recovery which sees unemployment low and earnings/growth staying solid. However, as we indicated at the beginning of Q2, signs of stress in the credit world continue to intensify globally, giving little wiggle room for financial markets to price in volatility coming from external factors, especially political risk.

The continuous flattening of the US yield curve is the most alarming sign of a possible recession. Currently the spread between the two- and 10-year Treasury yields is trading at 41 basis points, the lowest in 11 years. With the Federal Reserve expected to hike rates twice again this year (+50 bps) and four times next year (+100 bps) starting with today’s FOMC meeting while the 10-year yield continues to be compressed due to political risk, an inversion becomes very likely.

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10-year/two-year Treasury spread (Source: Bloomberg)

Since the financial crisis in 2008, we have been witness to a 'bear flattener' and with the information we have today, it is hard to imagine this will change anytime soon. While domestic and foreign investors are heavily invested on the long part of the curve, the hawkish policies of the Fed provoke short-term rates to rise faster than their long-term counterparts.

This calls the Fed’s forward policy into question as the neutral short-term rate of interest (the one that will have neither a positive nor a negative impact on growth) is now estimated to be between 2.5% and 3%, meaning that if the Fed continues as planned, by the end of this year we would be really close to the bottom of that range and at that point more interest rate hikes could become a real problem on top of an already overheated economy.

In order for the Fed to go through with its forward policy it is fundamentally necessary for the 10-year yield to trade well above 3%. Although this target seemed possible at the beginning of the year, now that we start to see weakness coming from over-leveraged emerging markets and political risks are rising due to the Trump administration’s approach to trade, it is possible that the 10-year yield will continue to trade around 3% without rising enough to accommodate further interest rate hikes. 

This brings us to the realization that unless the Fed changes its rhetoric, or less likely, the president takes a different approach to foreign policy, an inversion of the US yield curve is likely to happen.

Trade war and uncertainty

After the G7 meeting in Canada, it is clear that President Trump is not afraid of damaging relationships with trading partners, nor is he conscious of the implications that his acts may have on the domestic economy. After all, Trump seems to be motivated by nationalistic ideals aimed at supporting producers, without taking into account consumers who could suffer from rising prices as other countries retaliate with tariffs on politically sensitive sectors.

This attitude poses the biggest uncertainty of all, as it is hard to forecast how things will develop. While the economy is getting hotter and there are still opportunities to be made in the short term, it becomes harder and harder to make long-term investment decisions. This is why long-term investors, including lifers, are cautiously looking to put money at work in safe-havens such as Treasuries, keeping the long part of the US yield curve tapped for upside potential 

North Korea: not yet a done deal

Yesterday’s North Korean summit might as well not have happened. After the turbulence encountered during the G7 summit, Trump needed a victory and consequently signed a document that doesn’t give any realistic guarantee that the current situation will be changed. Denuclearisation is mentioned without timelines or details of what the word means, implying that the two leaders might have different ideas in mind that could provoke misunderstandings and friction in the future.

If negative headlines emerge regarding this topic, we can expect the yield of longer Treasury maturities to be dragged further down.

More bear flattening in the short term 

Two-year Treasury yields will continue to rise, especially if the Fed appears rhetorically confident on continuing its rate hike pattern for this year and next.  It is possible to see in the figure below that two-year Treasury yields have already broken the upper falling trendline, and while yields will probably continue to rise to the resistance level of 3.1%, it is possible to expect a cup and handle to test the supporting trendline.

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Two-year Treasury yield (source: Bloomberg)

While the yield in the short part of the curve will be rising, 10-year Treasury yields will be falling in the short term. Looking at the current US Treasury 10-year future contract (ZNC1) below, it is possible to see that there is potential for Treasury future prices to rise.

Thus, yields most likely fall but it is unlikely they will fall below the support level of 2.75% seen a couple of weeks ago. 

Therefore, looking at the short term, strategies focusing on the flattening of the yield curve will most likely give the best returns.

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US Treasury yield 10-year future (ZNC1)

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