For all those market mavens out there fretting about the relentless flattening of the U.S. Treasury yield curve, Federal Reserve Chair Janet Yellen has a message for you: Get over it. In response to her final question at her final press conference on Wednesday, after nearly four years at the helm of the U.S. central bank, Yellen effectively dismissed the current shape of the U.S. yield curve as little more than a technical anomaly.
“I think there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed,” Yellen said. The yield curve – the plot of all of the yields on Treasury securities of maturities from 4 weeks to 30 years – has long been studied by economists and investors as a signal of the health of the economy.
A steep curve, when long-dated yields are substantially higher than shorter-dated ones, is emblematic of a growing economy that is likely to produce inflation, the biggest driver for yields further out the time-to-maturity curve. A flat curve, when the gap between the two ends of the curve is narrow, is typically associated with periods when central bankers are working to combat inflation by lifting shorter-term interest rates, something the Fed has done five times now even though signs of inflation are scant.
And an inverted curve, when short-term yields are higher than long-term ones, has served as a classic precursor of economic recession. In the last year, the spread between 2-year and 10-year Treasury note yields, a benchmark measure of yield-curve slope, has collapsed from around 135 basis points to 57 basis points.
Between 30-year bonds and 5-year notes , another widely tracked measure, the spread has narrowed from 127 basis points to 62.
This has given rise to a lot of chatter in financial markets that the flattening curve signals the waning days of an economic expansion that dates from mid-2009, following the Great Recession. “Now there is a strong correlation historically between yield curve inversions and recessions,” Yellen said. “But let me emphasize the correlation is not causation.” Moreover, this time it’s different, Yellen argued.
The current flatness of the yield curve is likely attributable to a lack of something called “term premium”, or essentially a premium in yield that investors of long-date bonds demand in compensation for inflation risk. With little inflation risk, today’s term premium has effectively vanished. “Right now the term premium is estimated to be quite low, close to zero, and that means that structurally, and this can be true going forward, that the yield curve is likely to be flatter than it’s been in the past,” Yellen said.
And, she said, “if the Fed were to even move to a slightly restrictive policy stance, you could see an inversion with a zero-term premium.” Yellen’s comments may lift concerns about the yield curve for now, and allow the Fed under incoming chair Jerome Powell to continue with a gradual path of rate increases. But if spreads continue to narrow it is likely to cause tensions with investors and within the Fed.
Already St. Louis Fed chair James Bullard and others have flagged the risks of a Fed-induced yield curve inversion as a reason for policymakers to move more cautiously. Bullard argued recently that the curve could invert within a year if the Fed continues to hike.”