Yield Curve Flattens from Growing Demand for U.S. Sovereign Debt

Followers of conventional wisdom might say that a flat yield curve usually indicates that investors and traders are worried about the macroeconomic outlook.

But various indicators show the U.S. economy seems to fine. Also evident are Increased economic growth, an improving job market and reduced concern about inflation by the Federal Reserve.

BUY (I REPEAT BUY) THIS STOCK TODAY

This little known $15 company is currently cornering the market on a technology that’s crucial to the future success of not just Google but also Apple, Amazon, Facebook, Microsoft, Samsung and many more. The best part? It trades for only $15 right now. Those who take action now could position themselves for gains of 12,000% or higher.

To get the ticker symbol of this $15 company, click here.

However, the flattening yield curve is hinting that things may not be as rosy as they seem. The Treasury market’s longstanding yield curve is flattening as demand is firming for longer-dated maturities.

Plus, the 10-2 year spread, which is the difference between the 2-year Treasury Note and the 10-year Treasury Note, recently compressed by 10 basis points (bps) to 60 bps.

The continued curve flattening has been noticed by analysts and policymakers, but Fed officials have attributed the flattening to international demand for Treasuries due to sovereign yield differentials, rather than concerns about a slowdown in U.S. economic growth.

A case in point is the 199-point spread between the 10-year U.S. Treasury and the 10-year German Bund.

With the Federal Reserve not showing much concern over the flattening yield curve from recent interviews with Fed officials, the market remains certain that the Federal Open Market Committee (FOMC) meeting on Dec. 12-13 will produce a decision to increase the fed funds target range to 1.25%-1.50%. The implied likelihood of a 50-basis-point rate hike remains slim.

There was no significant change in inflationary expectations as the 5-year, 5-year forward rate, a measure of expected inflation (on average) over the five-year period that begins five years from today, stayed below the 2.00% mark.

Source: Federal Reserve Bank

A quick glance at sovereign yield worldwide shows that, within Europe, Greece is the only country with debt paying a higher yield than the United States.

In Asia Pacific, only Australia, New Zealand and South Korea offer a slight yield advantage, but not without a much higher level of inherent economic risk. One always can roll the dice on big yields offered by Mexico, Brazil and India.

Rather than a red flag getting waved about a possible recession ahead, I contend that foreign central banks and institutions possessing liquidity and freshly minted currency are continuing to pounce on U.S. government debt like a cat on tuna. And until wage inflation shows up in a material way, the yield curve will remain flat and, in turn, feed the stock rally further.

Base Case for Risk Assets Remains Sound

Although the current bull market is the second longest in history, and will become the longest bull market if it trades higher past August 2018, the technical landscape supporting an optimistic base case for a higher stock market is sound.

The 2-year yield already has been working higher for the past few months and, contrary to popular belief, a flattening yield curve that does not invert historically has shown to be a precursor to very strong equity returns.

Quite frankly, it is interesting that the conversation of yield curves gets so much attention.

The Bank of Japan (BOJ) basically eliminated the yield curve altogether. Core inflation in Japan is close to zero and its central bank has stated it is committed to an over-shoot of 2.0% inflation, which means the BOJ is committed to keeping the yield on the long end of its yield curve down for a long time.

In Germany, there is no yield curve and the European Central Bank (ECB) has announced it will be printing money until the fourth quarter of 2018.

It is the impacts of powerful central banks and not markets that manage the various yield curves. Thus, I’m not sure why we are talking about concepts from the ‘70s and ‘80s that were market driven when today’s Fed policy determines the path of the yield curve.

In my view, the Fed is content with a flattish yield curve. The costs of mortgages and credit are attractive, and the United States is one country that can ill afford higher interest rates against its $20 trillion mountain of government debt and expected higher deficits to be created in the near term by tax reform.

Due to the expectation of tighter Fed policy coming into view, I just don’t see the setup of a major market downturn on the horizon.

I think equity investors will shrug off a quarter-point rate hike. The breadth of the rally has been broad based.

It is not just large-cap stocks on the rise. Mid-cap stocks recently hit new highs, as did small-caps stocks. Rallies led by many stocks and not just a few tend to endure.

The current action is consistent with middle innings bull market conditions where investors should look to ride the back of the bull into 2018 with a high level of confidence. The flattening yield curve represents a bullish tailwind for high-yield assets.

I invite readers of this column to explore my high-yield advisory Cash Machine by clicking here to see how I am positioning portfolios heading into 2018.

Until next time,

Bryan Perry

Bryan Perry has spent more than 20 years working as a financial adviser for major Wall Street firms, including Bear Stearns, Paine Webber and Lehman Brothers. Bryan co-hosted weekly financial news shows on the Bloomberg affiliate radio network, and he’s frequently quoted by Forbes, Business Week and CBS’ MarketWatch.