Normal Yield Curve Doesn’t Mean Everything’s Normal

(Bloomberg Opinion) -- 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 U.S. 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 U.S. 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.

Over the last few weeks, the U.S. 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% at the market close on Friday, 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 normalization 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 U.S. 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 U.S. yield curve can be found in the evolving market perceptions of future central bank policies, in the U.S. 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 fueling growing concerns about the risk of future financial instability, economy-wide resource misallocations, and contrarian behaviors 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 program 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.”  

The more that markets internalize this shifting monetary policy sentiment inside central banks, the more that they will unwind the policy expectations that fueled several forces acting to invert the U.S. 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 U.S. bonds. Look for this phenomenon to also maintain the yield spread between German and U.S. bonds at its current lower range despite what will continue to be relative economic outperformance by the U.S.

Just as I argued in March that it was unwise to react to the inversion of the Treasury yield curve with extreme anxiety about a U.S. recession, it would be premature to celebrate the recent partial reversion as an indicator of significant strengthening of U.S. economic prospects. Instead, both are reminders of the extent to which traditional economic signals have been distorted by a prolonged period of extraordinary central bank policies. And they should also been seen as just one of the unusual consequences of a monetary stance that, imposed for several years on central banks by the lack of proper policy action elsewhere, will now see the hoped-for benefits give way to a broadening and deepening recognition of the unintended consequences and collateral risks.  

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He is president-elect of Queens' College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton. His books include "The Only Game in Town" and "When Markets Collide."

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