Bond markets increasingly pointing towards a slowdown

Week ending Friday November 10th 2017

A quiet week in data and in markets. News on tax reform was also slightly disappointing. Trump was out of the country on his Asia tour and that kept politics out of the news.

Yield curve trending to flattest since the GFC

The most interesting market indicator by far has been the slope of the yield curve. Short rates have been consistently moving up while long rates have been drifting down – until a modest reversal on Friday. The 10yr less 2yr yield spread has been hitting a series of lows unseen since the 2007/08 slowdown and recession. The spread dipped below 70bps in midweek before rebounding a bit to 75bps.

In the past we have suggested that a flat yield curve is normal when nominal growth expectations are steady at a healthy rate of growth and the whole curve is around 3-4% or so. For the curve to flatten at these much lower rates is a bad sign. The driver is the expectation of further monetary tightening indicated by the Fed’s intention to raise policy rates several more times. The flattening indicates the bond market is unconvinced that these attempts to raise policy rates will stick in the medium term.

“Raising rates” can lead to them dropping

The UK recently clearly indicated the power of markets to set rates and not the central bank. The Bank of England raised the policy rate in such a ham-fisted way that actual market rate expectation across the curve fell on the day.

While bond markets may be indicating a slowing economy, our NGDP Forecast is still holding up with nominal growth one year out at above 4%. The forecast takes a broader range of market views than just the slope of the yield curve – but markets often assume that bond markets are smarter than the others are.

Next week

Only the slippage in UMich consumer current conditions and expectations was notable in a very quiet week. Inflation expectations also moved up after having drifted down last month. Next week is big with both October consumer prices and October retail sales released on Wednesday 15th. Industrial production data is on Thursday.

The flattening of the yield curve may also be indicative of markets wanting to test the Fed Chair-designate Powell especially as he has previously said so little about monetary policy. In addition, the prospect of losing the very market-sensitive William Dudley from the NY Fed must also be worrying markets somewhat. Dudley has often been the man to ride to the rescue when Fed hawks have scared markets with excessively aggressive monetary tightening ideas.

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