Investors and policy makers alike have been paying close attention to the shrinking Treasury term spread, defined by the difference between long-term and short-term interest rates. Recently published economic research from the Federal Reserve Bank of San Francisco helps explain why. Their report, titled, “Economic Forecasts with the Yield Curve,” highlights how an inverted yield curve or negative term spread has shown remarkable accuracy in forecasting slowdowns in economic growth. A negative term spread or inverted yield curve “has correctly signaled all nine recessions since 1955 and had only one false positive in the mid-1960s” for the U.S. economy.
The recent flattening of the yield curve is, at a minimum, “flashing orange” for the U.S. economic outlook. However, another widely followed indicator in the bond market is telling a different story. Breakeven inflation expectations – the spread between nominal Treasury bonds and Treasury Inflation Protected securities (TIPs) – have been steadily moving higher, even as the yield curve flattens. In theory, higher inflation expectations should lead to a steeper yield curve as investors demand higher compensation to invest in riskier long-term bonds.
This week’s chart shows a 5-year history of the Treasury term spread curve and 10-year market implied breakeven inflation. The two spreads were highly correlated (both pricing in lower inflation) until the Federal Reserve began hiking interest rates in December 2015. Since then, their diverging paths have continued sending mixed signals about the risks of mounting inflationary pressures in the United States.
Successful fixed income investors must constantly understand and analyze the interplay of numerous signals in the bond market, including breakeven inflation expectations and the term spread. I view the mixed signals coming from these two indicators a function of unprecedented monetary policy accommodation still prevalent in Europe and Japan. The Treasury yield curve will normally flatten as the Fed tightens, but long-term Treasury yields have barely budged since the Fed’s initial hike in 2015, despite increasing signs the Fed will soon meet its 2% inflation target. The gravitational pull from low or negative rates in Europe and Japan will keep the U.S. yield curve flat until interest rates begin to normalize overseas.
 Federal Reserve Bank of San Francisco
 The Liquidity Preference and Expectations term structure theories
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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