US Recession Watch, December 2020 - Yield Curve Hides Slowing Economy

Federal Reserve Interest Rate Expectations (December 14, 2020) (Table 1)

US Recession Watch, December 2020 - Yield Curve Hides Slowing Economy

With no negative rates on the horizon and an FOMC that has said explicitly that interest rates will be low through 2023, it may be the case that traders have pushed up US yields – steepening the yield curve – in anticipation over forthcoming disappointment on the policy front. Expectations for an enhancement to the Fed’s QE program have subsided; it was previously anticipated that a shift to buying more long-dated bonds might occur in December. As this expectation of a major buyer in bond markets has subsided, prices have fallen, and yields have risen.

Using the US Yield Curve to Predict Recessions

The US Treasury yield curve remains normalized – long-end yields are higher than short-end yields – but we maintain that the yield curve is not an accurate reflection of the state of the US economy. Historically, the relatively faster rise by long-end yields compared to short-end yields occurs during times of expected economic expansion, so traders may be prone to interpret the yield curve movements as a sign that market participants believe that the worst period of uncertainty around the coronavirus pandemic is over.

US Treasury Yield Curve: 1-month to 30-years (December 14, 2020) (Chart 2)

US Recession Watch, December 2020 - Yield Curve Hides Slowing Economy

The Fed’s efforts to flood the market with liquidity have depressed short-end yields, helping keep intact an artificially steep of the US yield curve. The degregation of US economic data momentum coupled with the alarming surge in COVID-19 cases, in aggregate of daily tests, deaths, and hospitalizations, suggests that the US yield curve is lying, again. That the US yield curve is steepening and the net-result is a weaker US Dollar is a major red flag that something is amiss.

After all, that sounds a lot like a sovereign debt problem akin to what was seen during the height of the Eurozone crisis, no? The soundbites at the time were, “Italian/Spanish/Portuguese yields spike, Euro falls.” Time will tell if the US yield curve is not signaling higher growth, but instead risk of sovereign credit stress.

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