Abu Dhabi, UAEWednesday 20 November 2019

The normal yield curve doesn't mean everything is back to normal

Mohamed El-Erian argues that we should not rush to see this as a positive sign for the US economy

Traders at the New York Stock Exchange (NYSE) earlier this month. The US yield curve has been quietly undoing the inversion that had raised alarms over the summer. Photo: AFP
Traders at the New York Stock Exchange (NYSE) earlier this month. The US yield curve has been quietly undoing the inversion that had raised alarms over the summer. Photo: AFP

As we count down to this month’s meetings of the European Central Bank and the Federal Reserve, both of which are expected to maintain their monetary easing stance, the US yield curve has been quietly undoing the inversion that had raised alarms in the corridors of the world’s two most systemically important central banks.

Just as I had argued that the inversion was not a reliable signal of a coming US recession, we should not rush to see this return to more normal conditions as a comforting green light for what’s ahead for the economy. Instead, it is yet another reminder of how traditional market signs have been distorted by years of unconventional central bank policies.

It is yet another reminder of how traditional market signs have been distorted by years of unconventional central bank policies.

Over the last few weeks, the US yield curve has been slowly and gradually regaining its more traditional upwardly sloping shape whereby longer maturity bonds trade at a higher level than their shorter-maturity peers. On the most-watched segment of the cure, the so-called 2’s-10’s, the benchmark 10-year Treasury traded at 1.75 per cent at the market close last week, or 17 basis points above the yield on the two-year note. The curve for the 10-year bond and the three-month Treasury bill has also reverted to normal, though several of the intervening segments remain inverted for now.

It is hard to argue that the continuing normalisation has been driven by an improvement in economic indicators. If anything, these have worsened, including last week’s surprising drop in retail sales, raising concerns about household consumption, which has been the most robust part of the US economy. Moreover, the worsening of indicators has been even more pronounced internationally, particularly in China and Europe.

It’s no wonder the International Monetary Fund, among others, revised down its projection for global economic growth to the lowest level since the global financial crisis. I worry that even these latest revisions may not be enough to capture the drag from the slowdown in Europe and elsewhere in the world.

A better explanation for the restoration of the US yield curve can be found in the evolving market perceptions of future central bank policies, in the US and abroad.

Despite the weak global economic outlook, a growing set of signals has been coming out of central banks suggesting waning enthusiasm and appetite for the continued use of unconventional measures such as negative interest rates and large-scale bond purchases. Such easing is viewed as having limited, if any, sustainable benefits for economic activity.

Also, it is fuelling growing concerns about the risk of future financial instability, economy-wide resource misallocations and contrarian behaviours by those worried about their ability to secure their future economic security, including higher savings driven by an uptick in risk aversion and the threat to long-term financial protection products such as low-risk retirement planning and life insurance.

Such central bank signals include the loud and vocal public opposition by some current and former ECB officials to further policy easing and media reports suggesting a leaner appetite among the traditionally more dovish and centrist Fed officials for significantly lower interest rates. That can also explain why so many Fed officials who have been forced to resume a security-buying programme in response to dislocations in the wholesale funding market have gone out of their way to repeatedly echo Chair Jerome Powell’s words that “in no sense is this QE (quantitative easing)”.

The more that markets internalise this shifting monetary policy sentiment inside central banks, the more that they will unwind the policy expectations that fuelled several forces acting to invert the US yield curve, including indirect ones such as the enormous pressure on foreign investors to flee negative yields in Europe and Japan and go into longer-dated US bonds. Look for this phenomenon to also maintain the yield spread between German and US bonds at its current lower range despite what will continue to be relative economic outperformance by the US.

Just as I argued that it was unwise to react to the inversion of the Treasury yield curve with extreme anxiety about a US recession, it would be premature to celebrate the recent partial reversion as an indicator of significant strengthening of US economic prospects. They should be seen as one of the unintended consequences and collateral risks of a monetary stance imposed for several years on central banks due to the lack of proper policy action elsewhere.

Mohamed A. El-Erian is a Bloomberg Opinion columnist and the chief economic adviser at Allianz, the parent company of Pimco, where he served as chief executive and co-chief information officer.

Updated: October 21, 2019 01:54 PM

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