Flattening Yield Curve
The yield curve represents what investors are willing to accept by holding debt over short, intermediate and long-term periods. A typical yield curve is sloping upwards since longer term investors normally require a greater return to compensate for the risks of holding debt over many years. The extra return - referred to as the term premium - reflects the investor's view of future economic growth and inflation among other considerations. A rising term premium reflects concerns over excess supply of debt, credit quality, and higher inflation in the future; a falling term premium has these factors moving in the other direction. Over the past year or more, the term premium has fallen significantly, hence the fall in long-term rates.
Changes in the slope of the yield curve signify changes in the economic outlook. Over the past few months, the yields on long-dated US Treasuries, 10 years and up, have fallen and, at the same time short term rates have moved up. These two developments are related. Short rates have moved up in anticipation of the Fed increasing its overnight interest rate. Fed Chairperson, Janet Yellen, has spoken of the need to increase the policy rate in " the coming months" and other members of her committee have voiced similar views. In its most recent policy meeting, the FOMC continues to hold out the possibility for at least one or more rate increases before year's end. At the same time, investors in the long end of the bond market are saying that any short rate increases will have a detrimental effect on economic growth and that any policy shift must weigh that consideration. In effect, the long end of the curve is saying: increase short rates at your ( Fed`s) peril.
What can we learn from the recent behaviour of the yield curve?
Low yields are a symptom of economic malaise . Although there have been many criticisms of central bankers for introducing negative short interest rates, the central bankers are not responsible for the decline in long-term interest rates. Negative interest rates are not the problem. Slow growth and disinflation are driving longer rates to historic low levels. These bond yields are not the problem but are the symptom of widespread economic weakness that is not expected to improve over the next decade.
Low inflationary expectations are well-entrenched. Clearly, the negative nominal and real rates of interest are sending a powerful signal that those economies are going to experience very low growth without inflation for the next 5 to 10 years. There is a well-entrenched view that inflation and growth will remain very subdued over the next decade.
Shortage of quality debt.There is growing evidence that quality debt remains in strong demand and highly sought-after. The decline in the term premium on long-dated government bonds demanded by institutional and central bank investors supports this assertion.
Long term rates to remain low. The combination of strong demand and supply restraints will keep long bond yields at these levels or even lower for many years. Any change in the current direction of bond yields will not come from within the market itself. Rather yields will rise only if governments resort to aggressive fiscal policies that promote growth and higher inflation. As yet, there is no sign of any policy shift in that direction, especially in the US and the EU.
