Yields send conflicting signals over the US economy

Posted by Matt Simpson | 25/05/2017 04:29

We highlight three correlations which show the near-term may provide further hikes, further out it may be less pleasant. 

– 2yrs suggest Fed will continue to hike
– 2-10yr spread is out of sync with current hike path
– If Fed Funds and 2-10yr spread are to meet, a run to the short-end of the curve is the most likely method for this to occur
– Several gremlins lurk in the system which could make this event a reailty, further out
 
The 2yr yields continue to suggest that the Fed will continue to hike, despite traders and some fed members remaining sceptical over the velocity of inflationary pressures and their ability to hike further out. Over the longer-term, the 2yr has traded at a premium to the fed funds target during hikes and at a negative during cuts. It has also been very good at predicting the turning point of the fed funds more often than it has failed. The spread between 2-10yr yields have also been a good barometer as to where the Fed Funds target rate could be headed. At least that was the case prior to the GFC, before quantitate easing and unorthodox monetary policies were impelemted from major central banks. 

Up until the rate cuts in 2008 as the GFC unfolded, the general trend of the 2-10yr spread was that it tended to lead (or at least coincide) with major turning points of the Fed’s cycle. There were, and clearly still are occasions where the spread gets it wrong, yet the general nuance of the relationship was clear.
 
Following the GFC we can see the connecting gyrations between the spread and fed funds target were much larger before the Fed finally mbarked upon their third rise of this cycle. This can partly be explained by the turmoil of global markets in the aftermath of the GFC but also the unconventional monetary policy tools central banks were using; it created the hunt for yield and drove bond yields into negative territory – something which was theoretically not possible until a few years ago.
 
So, there does appear to be a disconnect between the 2-10yr spread and the Fed Funds target in recent years. By historical standards, the spread (whilst negative) trades much higher in relation to the underlying rates, which would initially suggest the Fed Funds are way too low of the spread is way too high. Most would agree that there is little chance of the Fed embarking upon an aggressive hike path which would suggests the 2-10yr spread is indeed too high in relative terms to history.  
 
Assuming this is the case, what could end the spread lower to come back to within the bounds of histrorical normality, during the Fed’s current hiking cycle? The simplest answer is for traders to rush to the front-end of the yield curve, due to some some marco or black-swan event. 
 
On a relative basis, money is flowing into 10yr bonds at a faster rate than the 2yrs, which is suppressing the 10yr yields in relation to the 2yr yield. This is commonly referred to as investing in the long-end of the yield curve and is a tendency which occurs when investors are happier about the outlook of the economy. The impact this has on the spread between 2-10yr is for the spread to narrow and this is what has been happening in recent months.  
 
So, for us to see a reversal of this we would need to see money flowback into the short-end to push 2yrs higher relative to 10yrs. In times of stress, investors switch to the short-end of the curve by pulling money out of the long. This would send 2yr yields higher relative to 10yr yields, and push the 2-10yr spread lower. This is what has happened during (and usually prior to) an economic downturn which sees the Fed cutting once more.

A correlation we would like to highlight is between the ISM manufacturing PMI and the 10yr – Fed Funds spread. We have covered the usefulness of PMIs at length over the past couple of years but, in short, they provide a glimpse at growth potential for the US and the global economy. F PMI’s are above 50 and expanding, this tends to lead growth and stocks higher. If they’re above 50 yet slowing, this tends to provide headwinds for US and global growth. If below 50 and accelerating we could be headed for recession. The 10yr – Fed Funds spread has been a good leading indicator for the PMI – and this is where we get concerned. The spread is moving lower to denote stress in the system yet the PMI peaks since 2010 have remained elevated if the leading quality of this relationship is to stand true, then PMI data should face headwinds and essentially predict slower growth for the US.
 
With the Trump administration struggling to pass inflationary policies, the promised tailwind for growth and inflation is sorely lacking. This may (or may already be) weighing on business survey’s which have softened in recent months. If leading indicators such as PMI’s continue to soften (as they are in China, Japan and US) then this is quickly becoming one of global growth in a low inflationary environment. Add to this that central banks now have eye-watering balance sheets and the impact of unwinding them is yet to be discovered in these unknown waters. If we throw into the mix that global debt to GDP is now 320%, US delinquencies for commercial and consumer loans are rising in tandem, student debt is unattainable at bubble-like levels, then there are enough gremlins in the system to bring the economy down. It is scenario’s like that that when the chickens come home to roost, we’ll see a rush to the short-end of the curve and the 2-10yr will surely be dragged back down to normality. And the above is irrespective of how hawkish the Fed can manage to raise before this occurs – yet the issue they’ll then face is being at relatively low rates, leaving fewer cuts on the table and the potential for QE4. 

Matt Simpson | Senior Market Analyst

A certified technical analyst, combining macro themes, monetary policy and business cycles to generate Forex and commodity trade ideas.