Publication - What yield curves are telling us - Speech by Benoît Cœuré, Member of the Executive Board of the ECB at the Financial Times European Financial Forum, “Building a New Future for International Financial Services”, Dublin, 31 January 2018
The US Treasury yield curve flattened considerably last year, reducing the spread between ten-year and two-year US Treasury yields to less than 60 basis points. When Alan Greenspan first referred to a bond market “conundrum” in 2005, the spread was around 80 basis points.[1] In the euro area, by contrast, the term spread remained broadly unchanged last year.
At face value, a simple reconciling factor of recent international bond price developments is the tightening cycle that has gained traction in the United States. It is well known that a rise in policy rates typically leads to a flattening of the sovereign yield curve as long-term rates tend to increase by less than short-term rates.
In my remarks this morning I will try to shed some more light on the potential factors currently affecting long-term rates. I will argue that, in and of itself, policy normalisation in the US cannot fully explain the pronounced flattening of the US Treasury curve. I will argue instead that two factors are likely to weigh on long-term yields in the US – and, in part, also on the yields in other advanced economies, including the euro area – which are fairly global in their nature and origin, namely cross-border capital flows and a depressed inflation risk premium.
The implications for policymakers are twofold. First, unlike in 2005, international capital flows mainly reflect portfolio rebalancing efforts by private investors and are less the result of interventions by official institutions.[2] This suggests that, while the present episode shares some similarities with Greenspan’s bond conundrum, changes in bond prices are likely to be driven by more price-sensitive investors this time around.
Second, because the decline in long-term inflation swap yields in recent years is mainly due to a fall in the inflation risk premium, market-based inflation expectations at these tenors remain well anchored at levels consistent with price stability, both in the US and the euro area. We therefore see no evidence that the long period of low inflation has undermined the credibility of central banks’ inflation aims.
Are current yield curves signalling recession risks?
Let me set the scene with a snapshot of the recent trend in the slope of the US Treasury and the German Bund curves.
You can see this on my first slide, measured as the simple difference between ten-year and two-year yields. You can see the marked flattening of the Treasury curve last year which has only recently come to a halt. The US yield curve is currently at its flattest level for more than ten years, with ten-year Treasuries yielding just about 60 basis points more than two-year bonds. At the start of 2017, the difference was around 130 basis points.
You can also see that the German Bund curve is currently about twice as steep as the US Treasury curve and has remained relatively stable, with ten-year bonds over most of the time yielding around 100 basis points more than two-year bonds – not very far from the average observed over the past 20 years.
My second slide focuses on the US Treasury curve. What you can see here is the ten-year yield and a model-based breakdown of the yield into its two main components: the average of the current and expected future short-term interest rates over the maturity of the bond and the term premium. All series are shown as cumulative changes since the start of last year.
Two facts can be drawn from this chart.
The first is that the recent marked flattening of the curve reflects what markets call a “bear flattening” – that is, short-term rates have been rising faster than long-term rates. This is evident from the fact that the ten-year yield – the blue solid line – today is about the same as it was a year ago. Short-term interest rates, meanwhile, have risen by around 90 basis points.
At face value, this would suggest that the repricing of interest rate expectations at the short end of the US curve has not been passed through to long-term rates. This interpretation is incorrect, however.
Indeed, and this is my second point, the broad stability of the ten-year yield masks two sharply diverging developments: a marked fall in the term premium – the yellow area – and an appreciable repricing by markets of the expected future path of short-term interest rates – the dark orange area. You can see this clearly on the slide.
Put simply, if it weren’t for the parallel fall in the term premium, ten-year Treasuries would trade some 50 basis points above their January 2017 levels and we wouldn’t be having a discussion about flattening. US long-term yields have resisted upward pressure only because of a considerable re-compression of the term premium. Only shortly after the UK’s referendum on EU membership in summer 2016 was the US ten-year term premium more negative than it is today.
This allows for one preliminary conclusion but begs one question.
The conclusion is that markets seem sanguine about the prospects for the US, and probably also for the global, economy. Judging from the average expected short-term rate over the next ten years, the markets appear to have shaken off some of the pessimism that caused them to tread very carefully over the past few years.
Past and currently expected policy rate changes are predicted to last. This also means that the flattening of the US yield curve is unlikely to signal a looming recession, as it may have done in previous business cycles.
The question, then, is what has caused the US term premium to fall to such an extent since the start of last year.
In answering this question, I will distinguish between two broad factors. The first relates to international portfolio rebalancing considerations and the second to investors’ views of the risks surrounding the medium to long-term inflation outlook.
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