The start of this year has seen the longer end of the yield curve flatten, although spreads to the shorter end of the yield curve are still large. The visible shorter end of the yield remains fairly steep in comparison.
When using estimates for the "shadow Fed Funds rate" , the shorter end of the yield curve is incredibly steep.
The 5-10yr part of the yield curve has flattened mainly because 10year bonds have proven to be much stickier than shorter durations. The 2 - 5 year portion of the yield curve has steepened a little, with yields around recent highs.
As the chart on the left shows, changes in the yield curve have been an excellent guide to changes in momentum in the cycle in the US (using the ISM index as a proxy).
Is this flattening in the yield curve signaling slower growth ahead? At this stage is probably not significant enough move to definitively say yes. Furthermore, the 2 - 5 year part of the curve has remained relatively steep, which doesn't suggest bond markets are getting bearish.
Indeed, this move seems to be more about adjusting to FOMC guidance than a big change in expectations for growth. The shorter end of the visible part of the yield curve has risen much more substantially than 10yrs largely as markets increase conviction that guidance will become reality.
One source of increased difficulty in understanding the current situation stems from policy rates being at the zero lower bound, so bonds shorter than 2 years are effectively squashed to zero.
But there has been research done to estimate what the effective Fed Funds rate might be if it could go below zero based on current financial conditions in the visible part of the yield curve (explained in this post).
These estimates suggest that the effective rate is strongly negative. It also suggests that the part of the yield curve that is below zero would be incredibly steep at almost 300bps.
This perhaps takes a leap of faith based on the econometrics backing the estimation of shadow rates. But it does suggest that rather flattening, some parts of the yield curve are becoming very very steep.
Another notable development is that implied inflation expectations on 5-year TIPs have shifted up towards 2% in the last week or so, which is the strongest level seen in since 1H13.
So what does this all mean? For me, much of the movement in the lower end of the curve has been about markets adapting their views on Fed guidance rather than being data driven. So far most of the data has been a little weaker but not enough so for analysts to abandon expectations for 2H14.
In some ways, extrapolating the logic from this view suggests that a significant further flattening in the curve seems unlikely. If FOMC guidance is to become a reality, then we should see growth and inflation indicators pick up a bit from here. It would seem odd for the yield curve to flatten a lot further if growth is getting better.
There is also the issue of the very low term premium to consider at present. If anything the risk here is that this widens under a stronger growth scenario, rather than flattens.
So markets may be more interested in adjusting the shorter end of the curve for now, but ultimately the reason why markets are pricing an increasing likelihood of Fed guidance becoming a reality should also drive longer term yield higher to a similar degree.
