Ahead of the Curve

Michael J. Kelly, CFA
Global Head of Multi-Asset
New York

25 July 2018

For over two years now we have been writing about the long-term effects of quantitative easing, yield curve control (YCC), and the distortion of the US yield curve by the ECB and BOJ to the point where the US yield curve’s signals no longer mean what they used to mean. In the old days, the Federal Reserve distorted the short end of the curve, the market alone controlled the long end, and the curve was a comparison of two views: market versus central bank. Today it has become central bank versus central bank.

This has by no means been a consensus view. Headlines continue to flash that the yield curve is signaling a recession soon. Just last week, Jeffrey Gundlach warned exactly that. And when you have a contrarian view, I’ve found you have to keep shouting it. So late last month, I put out another note, “Pay No Mind to the Yield Curve (It Ain’t What It Used To Be),” explaining why the yield curve is no longer a reliable recession forecasting tool.

Lo and behold, and with remarkable timing, the Fed published a paper that very same day titled “(Don't Fear) The Yield Curve.” It argued that the shorter portion of the yield curve (18 months forward versus three months forward) had at least as good of a track record as the more commonly quoted 2s to 10s (the 10-year yield minus the two-year yield). While these two moved in unison in the past, the shorter version is now steepening (signaling strength ahead) while the more traditional longer version is inverting. In the paper, the Fed steered readers toward relying more on the shorter one in this environment.

And it gets better. Former Fed Chairman Ben Bernanke was quoted last week saying exactly what we’ve been saying – that today’s yield curves have been distorted by central banks and no longer mean what they used to. This was, in a word, amazing. Central banks have never before admitted to distorting the markets.

It’s too early to know with certainty whether the next recession is coming in the next 18 months, but, in my view, the verdict is already in. In another stroke of good fortune, recent news reports have suggested the BOJ might soon ease up on its YCC, the mechanism through which the bank has been depressing the medium to long end of its curve, thus also pulling down the medium to long end of the US Treasury curve. Not surprising to us, the 2s to 10s immediately steepened, implying that the markets were never warning us about the next recession through the yield curve.

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