Flattening Yield Curve Isn’t Just the Fed’s Problem

If the yield curve continues to flatten, it might complicate the ECB’s task in exiting ultraloose policy

By Richard Barley

Gap between two- and 10-year U.S. Treasury yields

Source: FactSet

The flattening U.S. yield curve, a harbinger of possible economic trouble, has caught the eye of officials at the Federal Reserve. But a potential problem for the Fed is a worry for the rest of the world, too—especially the European Central Bank.

An inverted U.S. yield curve—where short-term rates rise above long-term rates—has a strong track record of being a leading indicator of recession. Last week, the gap between two-year and 10-year U.S. Treasury yields reached its narrowest since 2007, below 0.5 percentage point. If it were to continue flattening, the curve could invert later this year or early in 2019.

     The U.S. Federal Reserve building. Photo: Joshua Roberts/Bloomberg 

In addition, swaps measuring U.S. interest-rate expectations for 2021 have edged below those for 2020, notes Deutsche Bank, showing investors are thinking about the Fed cutting rates, not just raising them.

All that might sound a long way off for anyone else to worry about particularly.

But the timing matters because the ECB has locked itself into a very gradual path from exit. It isn’t expected finally to wind down its bond purchases until the end of the year. Rates are likely to rise only slowly after that. By 2020, the ECB might only just have exited its negative-interest-rate policy.

Change in eurozone consumer prices from a year earlier
Source: Eurostat

It is, of course, easier to tighten policy when the growth outlook is good. If the yield curve continues to flatten, however, and markets grow nervous about a hit to U.S. growth, that might at the least complicate the ECB’s task in exiting ultraloose policy. A U.S. downturn will undoubtedly affect Europe.

And if a real downturn were to emerge in the U.S.—Société Générale is forecasting a mild recession in 2019-2020—and spill over elsewhere, then a debate would start about what tools central banks had left. While the Fed now has some room to cut rates again, the ECB might be grappling with inventing new ways to provide stimulus.

True, there is plenty of debate over what message the U.S. curve is actually sending and how flat it is. UBS argues global quantitative easing has distorted long-term bond yields by reducing the term premium, or the extra yield investors demand for uncertainty about monetary policy.

But if investors fear a U.S. slowdown or recession and pull back from taking risk, that will tighten financial conditions. The ECB is trying very hard not to spook investors. Reaching the exit may be the bigger challenge.

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