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Read the article of “This key recession signal is broken”.
Treasury yields are behaving as if they are signalling a recession, but strategists say this time it's more likely a sign of something else.
The market has been buzzing about the flattening yield curve, or the fact that yields on longer duration Treasuries are getting closer to yields on shorter duration securities. In the case of 10-year notes and two-year notes, that spread was the flattest Friday than it has been on a closing basis since late 2007. The yield curve had turned negative in 2006 and stayed there for months in 2007 before turning higher ahead of the Great Recession. The spread was at 95 at Friday's curve but widened Monday to more than 96.
The impact of central bank easing and concerns about international developments, like the slowdown in China, may be what is really behind the move.
"Historically, a flattening curve pointed to a recessionary environment. However, historically the Fed was not running such a large balance sheet, rates were not effectively zero and we were not faced with a Fed attempting to remove accommodation into a sideways grinding economy rather than an actually strong outright growth profile," said Ian Lyngen, senior Treasury strategist at CRT Capital. "It's not clear to anyone that it's more than a strange residual to the fact that rates are so low and there was QE. ... But it does historically suggest a slowing of the broader economy.
" Both the European Central Bank and Bank of Japan instituted negative yields and other easing programs. The Japanese 10-year yield was a negative 0.109 percent Monday while the 10- year German bund was near a historic low at 0.141 percent. That makes the U.S. 10-year's 1.75 percent yield relatively more attractive.
QE or quantitative easing is the program under which the Fed bought Treasuries and mortgage securities. Other central banks have similar programs.
RBS strategist John Briggs said the curve flattening is the result of stronger demand for long end, not a sell-off at the short end. "Usually a curve flattening when the Fed is raising rates means the front end is going up in yield. This is the long end going down in yields," said Briggs, head of strategy at RBS. The two-year was higher Monday at 0.78 percent.
"If the Fed is on hold and purposely generating an inflation overshoot, usually that leads to a curve steeper. I think it is interesting that the curve is flattening with the Fed on hold," he said. "I think what we're seeing there is the overall need for yield in a world bereft of yield.
Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management, said the fact that the curve is the flattest it's been since before the financial crisis is not really meaningful. "As long as the market perceives international weakness (see China's weak data released over the weekend), then back-end yields will stay low and the curve will flatten," wrote Caron in an email. He said there is a disconnect between what Fed funds futures say about a very low probability of a rate hike in June, at just 6 percent, and the yield curve.
"But you wouldn't have guessed that by the recent flattening of the curve. Essentially, the yield curve move is giving you little information about the Fed. It's mainly international," he wrote. "I assign no significance to the curve being flatter than 2007 as a result."
Source: CNBC LLC, 16 May 2016.
Answer the following questions.
(a) The yield curve has been closely monitored by many market participants. Critically discuss three important uses of the yield curve.
(b) Explain how a central bank could change the shape of the yield curve by conducting various monetary policy measures.
(c) Treasury yields are behaving as if they are signalling a recession, but strategists say this time it is more likely a sign of something else.
Do you agree with the view of these strategists? Justify your stance.