What the Shrinking Yield Curve Is Really All About

(Bloomberg View) -- The bond market is getting a lot of attention, specifically the shrinking gap between short- and long-term yields, which has come as a surprise. The immediate logic, however, behind this development isn't difficult to fathom: short-term yields are getting support from the Federal Reserve's desire to keep increasing interest rates, while long-term yields are falling in response to recent economic data that has been decidedly disappointing.

And the disappointment is not limited to various indicators suggesting inflation is slowing, which the Fed likes to say is transitory. The Bloomberg Economic Surprise Index, an aggregated read, is the weakest it’s been since November, and the Citi Surprise Index is at its lowest level since early 2016.

The curve’s behavior is hardly without precedent. Into and during pretty much every Fed hiking cycle it has flattened, though it tended to flatten in a bear market as short-term yields rose more than long-term yields. The exception was the last hiking cycle from 2004 to 2006, when long-term yields fell and remained in a sideways range for much of the time.

What is also surprising is how the curve has been nonplussed over the Fed’s intent to start shrinking its $4.5 trillion balance sheet later this year. This attitude, or lack of one, perhaps hints that the market doesn’t expect that shrinkage to go very far, or, in other words, add much to the supply of bonds. That process, of course, means that what the Fed doesn’t buy the market will have to absorb.  There are some very sound reasons behind that logic, and this, too, plays into the curve's behavior.

The chart below shows the difference in yields between 2- and 10-year Treasuries and 5- and 30-year Treasuries going into rate hikes. The vertical lines represent the start of hiking cycles.

First, the process will start gradually, which may have been an immediate source of relief to the long end of the market. Second, the largest increases in Treasury Department issuance going forward will be in the shorter end of the curve.  (Part of the rationale for that view stems from Treasury’s April Survey, “Aggregated Perspectives on Auction Sizes.”) Third, with a goal to eventually have the entire balance sheet in Treasuries, at some point the rolling off of the Fed's mortgage bond holdings will actually drive a shift in buying into Treasuries.

Finally, the curve's behavior hints at a slower pace of economic growth. That puts the market at odds with the Fed, which explains why the market sees the chances of one more rate hike this year at less than 50 percent.  It follows that balance sheet reduction could stop in the event that economic conditions don't evolve as the Fed expects. In other words, if the market’s pricing of federal funds futures is more dovish than that of the Fed, it's consistent that its anticipation of balance sheet reduction would also be more dovish.

There’s a somewhat arcane element at work as well. In January, former Fed Chairman Ben Bernanke wrote a commentary, “Shrinking the Fed’s Balance Sheet,” under the auspices of the Brookings Institution.  Bernanke urged that the Fed should not start the process until rates were "comfortably away from their lower effective bound.” Not that it’s important, but I’m not sure the two rate hikes since he wrote the item qualify.  He also advised Fed officials to provide guidance on the ultimate size of the balance sheet.

This is where it gets interesting. What I took away is that the balance sheet, according to Bernanke, ultimately will be larger than it was pre-crisis -- no surprise -- but substantially larger.  Why?  He cites as one issue the increase in the public’s demand for currency. Before the financial crisis, currency -- amounting to $800 billion -- was the liability on the Fed's balance sheet and Treasuries were the asset. Today, currency in circulation is $1.5 trillion and he cites Fed estimates that between rising nominal gross domestic product, low rates and higher overseas demand, currency in circulation will reach $2.5 trillion at least in the next 10 years. There’s no economist out there who forecasts the balance sheet to shrink to less than $2.5 trillion over that time frame.

Bernanke goes on to point out that given the high level of bank reserves today, “it’s impossible to manage interest rates through small changes in reserves,” so the Fed now manages short-term rates by setting rates, i.e. a "floor system." He cites the level of reserves needed to be more than $1 trillion and growing. Combining that with the currency demand cited earlier, he thinks the "optimal size" of the Fed’s balance sheet is bigger than $2.5 trillion and could reach $4 trillion or more in the ensuing decade. As Bernanke wrote, “In a sense, the U.S. economy is ‘growing into’ the Fed’s $4.5 trillion balance sheet, reducing the need for rapid shrinkage over the next few years.”

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

David Ader is chief macro strategist at Informa Financial Intelligence. He was the No. 1 ranked U.S. government bond strategist by Institutional Investor magazine for 10 years.

To contact the author of this story: David Ader at dader2@bloomberg.net.

To contact the editor responsible for this story: Robert Burgess at bburgess@bloomberg.net.

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