My thoughts on yield curve.
Why is it predictive of a recession? Two reasons, among others I suppose:
- Direct: banks make money lending at the long rate, to get that money they pay interest at the short rate, so when the long rate is less than the short rate, banks don't want to lend so much. Credit tightens and the economy sinks.
- Indirect: long rates represent bond investors' expectations of future economic growth and inflation, when long rates are below short rates it implies bond investors expect future low growth and/or future deflation, and stock investors take their cue from bond investors.
What is pushing short rates up?
- Fed sees inflation rising (low unemployment, high oil/commodity prices, tariff threats). Fed also sees huge fiscal stimulus (corporate tax cut, rising federal deficit). Fed has been wanting to normalize Fed Funds rate to rebuild their main monetary stimulus tool in time for the next
recession. So Fed is pretty determined to raise Fed Funds rate.
- Fed is allowing its multi-trillion dollar balance sheet run off, meaning letting their treasury and agency bonds mature without buying new ones. A maturing bond is by definition a short-duration security.
- Aforementioned ballooning federal budget deficit is forcing Treasury to increase debt sales, including at the short end (2-3 year). $1 trillion of Treasury debt issuance expected in 2018.
What is causing long rates to lag?
- Other major economies are still pursuing very loose monetary policy, with German 10 year bunds yielding just 0.32%.
https://www.bloomberg.com/markets/rates-bonds/government-bonds/germany Japanese 10 year notes yielding just 0.02%. Those ultra-low rates hold down US Treasury 10 year yields, by shifting demand to Treasuries.
- Treasury debt issuance has been emphasizing the short end (I'm reading, haven't confirmed it).
- Increased investor perception of risk is increasing demand for so-called safe-haven assets.
I'm not a bond guy, may well be other factors at work too.