Yield Curve for the Cycle
March 21, 2022
The financial press will likely be focused on curve flattening in the months ahead, and it’s signaling for an eventual recession. We expect more curve (2/10 and 5/30 curves especially) flattening in the medium-term driven by reduced GDP growth rates, lower neutral policy rate (~2.5% vs. ~4.5% in last cycle) and Fed balance sheet normalization. The Fed currently owns ~25% of the Treasury market, and balance sheet normalization (QT) will put downward pressure on the yield curve because the Fed’s QE operations were largely focused on buying short-duration paper. US Treasury financing operations remain focused on shorter-term bills/notes, which means increased supply at a time when the largest buyer steps aside. Increased supply/potentially reduced demand makes for lower Treasury prices/higher yields at the short-end of the curve. The Fed’s QT operation means the recession signal quality of the 2/10 curve should be temporarily shelved. In it’s place, we recommend following the shape at the front-end of the curve (1month-2-year), which has been a more reliable recession indicator since the Fed began to reduce its neutral policy rate with its US productivity estimates in ~2008. The current 1mo-2 year yield curve is the steepest its been in 10 years.