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Fear of flattening (yield curve)
1/19/2019 3:47:03 PM
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By Fund Library News Wire  | Thursday, January 11, 2018


By Aubrey Basdeo, Managing Director, Head of Canadian Fixed Income, BlackRock

What does a flattening yield curve mean these days? Perhaps not what it used to. No doubt, the slope of yield curve, as measured by the spread between two- and 10-year government bonds, has been flattening since 2014 in both Canada and the United States, and the trend has recently intensified: During the month of November, the spread between Canada 10-years and two-years fell by 10 basis points, while the Treasury curve tightened by nearly 20 bps. As we headed into December, the curve sat at its flattest level since the Great Recession.

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 bonds.

* 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 America.

* 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 record highs.

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.

Notes and Disclaimer

© 2018 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared in the BlackRock Canadian Fixed Income Portfolio Management Commentary Dec. 2017, on the BlackRock Canada website.

Important information

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

© 2017 BlackRock Asset Management Canada Limited. All rights reserved.

iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. Used with permission.
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