The Flattening Yield Curve

Despite a healthy equity risk premium and strong fundamentals, a flattening yield curve is causing concerns among investors. The gap in long- and short-term borrowing is hovering near its lowest in over ten years.

While it might be true that flattening yield curves historically have significantly increased the probability of recessions, incoming NY Fed chief John Williams, and Chicago Fed President Charles Evan appeared to downplay concerns.

Williams cautioned investors to wait for the shrinking balance sheet to help steepen the yield curve through upward pressure on longer-term rates.

Overall, increasing spending by the US with lower expected Tax revenue are resulting in an overall higher expected tax deficit. Increasing deficits for the US budget should steepen the curve in the future.

Recent research conducted by the Fed has also anticipated a decline in term premiums, which would result in an overall flatter term structure for a given recession probability. Thus, a probability model based on a historical sample is likely to overestimate the current probability of a recession. This research performed during February 2018, suggested that the probability of a near-term recession has actually declined slightly since late 2011, despite the flatter yield curve.

Despite such signs, the flattening yield curve could prove a temporary blockade towards rising interest rates.

Keith Knutsson of Integrale Advisors commented, “It remains important to understand the fundamentals of a marketplace, and not trade purely on historical associations. I remain most concerned about macroeconomic conditions when there is a lack of fear, rather than when there is not.”