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Why the Flat Yield Curve Doesn’t Suggest an Impending Recession

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VanEck

Number two, the higher fiscal deficit picture because of the tax law, so that has raised this issue. It projects into 2019 as well. If we’re running big deficits, meaning the government has to sell bonds, well, bond prices might go down and yields might go up, so that’s number two.

Number three is I think that the Fed has a lot of confidence now in the continuing normalization. They started, the monetary base flattened out two years ago, and they have been raising rates and transmitting that, so why not continue? I think this Fed is very comfortable continuing that. You know, on the other side, everyone is saying, “Well, rates should correct or the yield curve’s flattening and that’s going to portend a recession.” And yes, there’s been a lot of chatter about that. But really despite positioning, rates have really stayed up there pretty high without a big correction so far this year. So that’s still our base case.

Market Realist

The yield curve has been getting flatter over the last couple of years. Usually, this trend suggests that the economy is headed toward a recession. However, this time around, that suggestion may be slightly misleading for a couple of reasons.

Long-term Treasury (TLT) yields have been hammered down over the last ten years as a result of the Fed’s unprecedented quantitative easing programs, in which the Fed pumped money into the economy by buying long-term Treasury bonds. This move caused those bonds’ yields to decline, as the graph above shows.

Also, as the Fed hiked funds rates, short-term rates have risen over the last couple of years. The combination of the two factors has led to the flattening of the yield curve. So this time around, a flat yield curve may not necessarily mean a recession is coming.

Also, as the Fed continues to wind down its hefty balance sheet, long-term Treasury yields are likely to increase even further.

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