It is well known that an inverted yield curve (that is, one in which the rates in the short part of the curve are larger than the longer term rates) is a strong indication of the end of the expansive economic cycle. Although in some cases it has given false signals of recession, the slope of the curve between the reference to 10 years and the 12-month rates has been a fairly reliable early indicator of the beginning of an economic contraction.
Since 2014, the US curve has been gradually losing ground. This has been possible due to the beginning of monetary normalization by the Federal Reserve, which has caused the shorter terms of the curve to rebound while, at the same time, 10-year rates have remained very stable throughout the period. of the last four years.
With a current slope in the environment of 0.68%, in the event that the expectations of three increases in rates by the Fed in 2018 are fulfilled and assuming 10-year rates at levels similar to the current ones, the slope of the curve it would flatten completely in the final part of the year and we would enter 2019 with the inverted US curve. The relevant question now is this: can we expect that in this case the rate curve will once again anticipate the arrival of an economic recession in the United States?
The answer to this question is not simple, given the huge volume of monetary stimulus put into operation by the main central banks of the world. In this sense, There is no lack of voices that indicate that it would be the first time that the US economy enters into a recession with real interest rates (nominal rate minus inflation expectations) that are so low. On the other hand, many analysts suggest that as the balance of central banks decreases, while the programs of bond purchases are ending in other geographies such as the Eurozone and Japan, long-term rates will tend to appreciate. progressively, thus compensating the increases registered in the short part of the curve.
Two factors cause rebound of the returns
While waiting to confirm these hypotheses in the coming months, there are other factors that have slowed the rebound of returns in the long part of the curve. Specifically, the maintenance of real interest rates at very depressed levels and, above all, the almost total absence of inflationary pressures (with some exceptions such as those seen in recent weeks), which has meant that the expectations of inflation have not risen. long-term inflation and that investors do not demand significant compensation for investing for longer terms. In effect, the term premium is very depressed and is trading even in negative territory.
For all this, to avoid an inversion of the US rate curve (in Europe the slope is much higher and is currently around 120 basis points), one of these three things would have to happen. First, that the Fed stops raising interest rates, or that it does so more slowly than expected, which does not make much sense in the current environment of strong economic growth in the United States.
Second, there should be a rebound in real interest rates. For this to happen, it would be necessary to increase the expectations of US economic growth in an additional and significant way. In these moments in which the US economy is at full employment levels and growing even above its potential rate, it seems difficult that this scenario of additional acceleration of growth expectations could occur, which would only be feasible in case of that there was a relevant advance in the levels of productivity.
Finally, it would be necessary to increase inflation expectations. With the recent rebound in oil, we are also beginning to see an advance in long-term inflation expectations, which in the case of the United States is already approaching 2.10% within 10 years. This element is perhaps the most likely to be complied with, especially if we take into account the fiscal stimulus approved by the Trump Administration and that could reheat an economy that is already operating at full capacity. This could be the factor that would allow a rebound in the long types of the curve during the next months.
A rebound in inflation
On the other hand, the greater uncertainty about future inflation would cause the term premiums to rebound, which would also have a beneficial effect on the slope of the curve. In addition, we must indicate that there are structural obstacles so that we can expect upturns in inflation expectations, such as globalization, the irruption of technology or population aging. Likewise, the disappointing evolution of wage costs (until last week) was another impediment for general inflation to infiltrate the core of the economy.
In short, unless the long-term interest rates experience a significant advance throughout 2018, it is a feasible scenario that the US rate curve reverses in the coming months, giving a negative signal on the maintenance of the economic cycle in United States. At the other extreme, if it is possible to avoid the loss of slope, it will be at the cost of the fall in the prices of sovereign bonds in the United States, which would probably extend to other geographies and that would more than justify the maintenance of a tactical position of caution. in this asset class.