A lot of investor attention is now focused on the yield curve, which has flattened considerably over the past several weeks. Since an inverted yield curve is typically a strong recessionary signal, the fear is that we may be close to a recession. However, other macro economic data suggests that is not the case. Our own research into this topic finds that yield curve compression by itself is not indicative of a recession. Only inversion is, and that too when the Federal Reserve (Fed) is simultaneously raising the federal funds rate.
Yet a flattening yield curve is not a positive sign for the economy. It pushes investors to become more defensive – risk premia for long-term investments reduce and investors are comfortable parking money in short-term instruments. Profit margins also reduce for banks, which are a key conduit for credit growth.
The spread between 10-year treasury yields and 3-month (10y-3m) and 2-year yields (10y-2y) are now at their lowest levels since 2007. The 10y-3m spread has compressed 88 basis points (bps) in 2017, while the 10y-2y spread has shrunk by 68 bps (as of December 12th). Most of the compression occurred in the first half of the year and so this is not a recent phenomenon.
Note that spreads still have some way to go before outright inversion. The 10y-2y spread was lower than the current level of 59 bps across most of the five-year period between 1995 and 2000, when the U.S. economy experienced a technology fueled boom.
In this piece, we try to understand some of the dynamics behind curve flattening, giving us some intuition into whether this will continue.
The simplest explanation for the flattening yield curve is that the Fed is tightening policy and raising rates on the short-end. The economy is growing at a steady pace, the labor market is tightening, and it is likely that we will see some fiscal stimulus in the form of tax cuts, giving them more than enough justification to raise rates at this time.
Typically you would also expect to see rates at the longer end of the curve rising in this scenario, especially early in the tightening cycle. However this has not been the case in 2017 and hence the curve has flattened.
Now, inflation numbers have underwhelmed recently, with core personal consumption expenditures (excluding food and energy) falling from 1.9% at the end of 2016 to 1.3% at the end of September. At the same time, market expectations for inflation have remained fairly anchored around the 2% level. The 5-year/5-year forward inflation expectation rate, which is a measure of expected inflation over the 5-year period that begins 5-years from now, rose steadily in the latter half of 2016 (especially after the Presidential election) to over 2.0% – and it has hovered around that level for most of this year. The measure was at 2.06 at the end of 2016 and is now at 2.00.
Inflation expectations hit a low of 1.8% in June 2017 but have rebounded since then. Yet yield spreads continue to compress as long-term yields remain locked in a fairly tight range.
It does appear that inflation expectations have an upper bound close to the 2% mark. This is probably because investors believe the Fed’s 2% inflation target is in fact a ceiling as opposed to a level around which inflation is allowed to symmetrically fluctuate i.e. the Fed is unlikely to let inflation remain above 2% for a sustained period of time.
Despite the Fed raising rates at the short end of the yield curve and inflation expectations remaining fairly steady, yields on the longer end of the curve have generally fallen over the course of 2017. Long-term yields have been trapped in the tightest range in decades. The question is why.
The yield on a long-term bond can be broken into two components:
1. The expected path of future short-term rates
2. The term premium
The first piece is essentially dependent on expectations of future Fed policy in the face of economic growth and inflation (or lack thereof).
The term premium is the extra return that investors demand of a long-term bond over a series of short-term securities. For example, if investors expect the average short-term rate to be 2.0% over the next 10 years, a yield of 2.3% on the 10-year bond would imply that the term premium is 0.3%. It is bit of an esoteric concept, not least because they cannot be directly measured but must be estimated from short and long-term interest rates using a model.
Usually, the term premium tends to be positive since investors want extra compensation for holding a long-term bond. The perceived risk of holding long-term bonds greatly influences the term premium and typically, the biggest risk is an unexpected rise in inflation. Since the early 1980s however, inflation fears have receded and bond investors have been willing to accept less compensation for bearing inflation risk.
The term premium was below zero between January 2016 and October 2016, with investors demanding no extra compensation (in fact, negative) for holding a long-term bond. However, as the chart below shows, term premium quickly made its way back above zero after the election as inflation expectations jumped.
Since then, the term premium has once again fallen below the zero level, even in the face of fairly steady inflation expectations. This suggests that there is sustained demand for long-term treasuries, despite a global economic environment that is steadily improving and general risk-on atmosphere in global equity markets.
So let’s take a look at where is this demand coming from.
It would seem obvious that Europeans are turning toward U.S. shores in search of yield, as a significant portion of yield curves across the continent are in negative territory thanks to European Central Bank (ECB) policy. Yields are negative through seven years in Germany and Netherlands, and through five years in France.
The following chart shows the spread between U.S. treasury and German bund yields (10-year spread). The spread rose to record levels after the ECB instituted negative rates in Europe in June 2014, and then jumped even higher soon after the U.S. presidential election, when U.S. yields rose on the back of expectations for fiscal stimulus.
In addition to negative yielding bonds, Europe also faces a shortage of safe assets issued within the euro area. As Mathew Klein (FT) points out , this shortage of euro-denominated safe assets is a feature of what European officials believe is good policy.
European policy-makers would like to provide emergency lending only after private creditors are forced to take losses, and hence market discipline would be imposed on euro-zone members. The downside of this is that if defaults are now in play (in contrast to the pre-debt crisis era), the supply of safe euro-denominated assets collapses.
To understand the magnitude of the shortfall, we looked at the amount of debt issued by AAA-rated sovereigns in the euro area going back to 2007, pre-financial and European-debt crises.
Out of a total of 6.1 trillion euros in combined government debt for the euro area in 2007, close to 3.8 trillion euros was from AAA-rated countries – Germany, France, Spain, Netherlands, Austria, Finland, Ireland and Luxembourg – making up 62% of the total.
Europe has continued to issue debt over the past decade, and the combined total government debt for the area has risen to 9.6 trillion euros. Yet the total amount of AAA-rated debt has actually fallen over this period thanks to higher default risk and credit rating downgrades. Only three countries are now rated AAA and their combined debt adds up to 2.6 trillion euros – just 27% of the total figure.
The following chart shows the extent to which euro-denominated safe assets (government debt from AAA-rated countries) have collapsed over the past 10 years. The big drop occurred in 2012 as the debt crisis raged on, when S&P and Moody’s downgraded their ratings for France.
Europe could increase the aggregate amount of safe assets by issuing something like European Safe Bonds , a union-wide safe asset without joint liability – the idea involves taking sovereign bonds from different European countries and packaging them together into safe bonds that would then carry various levels of risk, i.e. securitization. In theory, this would weaken the link between domestic banking sectors and their governments.
The problem is that even if this was carried out, it probably would not come close to replacing the deficit of euro-denominated safe assets. Between 2007 and 2016, the euro-area has increased its aggregate government debt by more than 3.5 trillion euros – but AAA-rated government debt has actually fallen by 1.2 trillion euros over this period!
To make matters worse, Europeans have also started to save more in recent years, even as they run out of euro-denominated safe assets to buy.
One of the biggest, and probably under-appreciated, phenomena that has taken place since the financial crisis and the European debt crisis is the fact that domestic consumption and investment has collapsed in Europe.
A little background will be useful here. For any open economy, the current account and the capital (or financial) account should balance out. The following graphic shows what makes up these accounts – the green boxes indicate items for which payments flow into a country and the red boxes show payments that flow out of a country.
Any country that saves more than it consumes or invests must export their excess savings to another country that consumes/invests more than it saves. So the whole world balances savings and investment.
Also, any country that saves more than it invests is basically producing more goods and services than it can absorb domestically, and so it must export excess production. So the current account and capital account balance out to zero.
For example, the U.S. has a trade deficit, meaning it imports more than it exports, and so the current account is negative. This also means that the capital account is positive (a surplus) – meaning that the U.S. experiences net capital inflows. There are more foreigners investing their excess savings in the U.S. – purchasing assets like stocks, bonds, factories, businesses and real estate – than there are U.S. nationals purchasing foreign assets. The net inflow of capital to buy assets in the U.S. is in turn used by Americans to buy more foreign goods and services.
On the other side would be countries like Germany and China, who produce more than they can absorb domestically and are net exporters, resulting in a current account surplus. The rest of the world buys their products and pays them for it – subsequently, their excess savings are pushed out to the rest of the world and so they have a negative capital account.
Back to Europe …
After the euro was created in 1999, investors (primarily banks) in countries with excess savings, like Germany and Netherlands, pushed it out to other countries within the euro-area, believing that default risk was eliminated.
By the mid-2000s, countries like Spain, Greece, Ireland, Portugal and eurozone members in Eastern Europe all saw significant current account deficits as money rushed in – eventually hitting a peak in 2007-2008. The U.S. housing market was also a recipient of excess savings from Europe, inflating the bubble even more. We all know what happened next.
However, more pertinent to our current analysis is what has happened since the crisis seemingly ended.
The debt crisis that hit Europe resulted in a significant shift in behavior as the crisis-hit countries pursued austerity. The next chart shows how current account balances have evolved in the euro-area since the crisis, telling us how savings and consumption/investment behavior has changed in the region. We created three groups of countries based on their current account balances in 2007-2008.
Group 1: Countries with a significant surplus (greater than 2% of GDP): Germany, Netherlands, Austria, Finland, Luxembourg – making up 38% of the euro-area economy
Group 2: Countries with a significant deficit (less than -2% of GDP): Italy, Spain, Greece, Portugal, Ireland, Slovakia, Slovenia, Lithuania, Latvia, Estonia – making up 37% of the euro-area economy
Group 3: Countries with a relatively small deficit/surplus (within +/- 2% of GDP): France, Belgium and Malta – making up 25% of the euro-area economy
The chart shows an enormous shift in behavior for countries in Group 2 (orange line in the chart) – the countries most impacted by the crisis. These countries had a weighted averaged current account deficit of -6.1% in 2007, but now have a surplus of 2.1% (2016). The current surplus is not huge but the swing is. Simply put, the countries most severely hit by the crisis have swung the pendulum significantly from the consumption and investment side to the savings side – they learnt their lesson really well.
On top of that, countries like Germany and Netherlands, who were the big savers prior to the crisis, have only increased their savings since then – the weighted average current account surplus for Group 1 rose from an already high level of 5.8% in 2007 to 6.7% as of 2016. Countries in Group 3, like France and Belgium, have not seen a big shift over the past decade.
The result of this is that Europe is now the world’s largest net lender. The following chart shows current account balances as a percentage of world GDP for various regions as well as the U.S., Japan and China.
Up until the crisis, emerging markets (EM) were the ones pushing their excess savings abroad. China played the biggest role, but even other Asian countries who are net exporters and learnt their own lessons after the Asian financial crisis in the late 1990s. However, EM net savings (gray line in the chart) have fallen relative to world GDP in the ensuing years. Meanwhile Europe (green line) became the world’s largest net lender on the back of increased savings and a consumption collapse in the crisis-hit countries.
Japan has stayed more or less steady over the past decade while the U.S. continues as the world’s largest net borrower, albeit to less of a degree than it was during the height of the housing bubble.
Of course, if aggregate savings in the euro area have steadily increased since the crisis, the question is where is it going. Prior to the crisis, we know excess savings flew out to fund bubbles in peripheral Europe and the United States. How about now?
Since the other side of the current account is the financial or capital account, looking into the latter gives us a better understanding of financial flows in and out of the euro area as consumption and savings patterns changed in recent years. The Financial Times ‘ Inside the balance of payment series ‘ from earlier this year was very helpful for our analysis.
The ECB’s balance of payment data for the euro area confirms that excess savings are indeed fleeing the euro area. The chart below shows cumulative net financial flows for the euro area since 2009.
What is striking in the above chart is how the euro area has seen net financial flows race out of the region since the middle of 2012, which is when the big shift from consumption to savings started. As Klein notes in the FT’s balance of payment series , the turn in net flows coincides with European Central Bank (ECB) president Mario Draghi’s pledge to ‘ do whatever it takes to preserve the euro ‘ in his speech in London on July 26th, 2012 – which had the ultimate effect of lowering European bond yields and borrowing costs for the crisis countries.
Curiously, even as the economy has mended on the back of ECB support, we continue to see net flows out of the euro area. This includes 2017, which has seen a marked rise in Europe’s economic fortunes.
Balance of payment data also breaks down how capital flows are being invested (see footnotes for more on this), and data for the euro area tells us that the bulk of net financial outflows are being used to purchase foreign debt securities.
The chart below shows annual purchases of foreign debt securities within the euro area since 2009. The buildup began in 2012, when Draghi made his pledge to do whatever it takes, but the pace has clearly accelerated since 2014, which is when the ECB lowered the deposit rate below zero for the first time. Europeans purchased more than 1.4 trillion euros worth of foreign debt between January 2014 and September 2017, more than four times the amount purchased in the prior five years.
Purchases of foreign debt securities over the first nine months of 2017 have already exceeded prior years. So the trend continues despite the European economy picking up steam recently.
Foreign financial flows into Europe – to buy equities, direct investments in European companies, and others (like repos, derivatives) – have been overwhelmed by Europeans using their savings to buy foreign debt, especially since the middle of 2014. This clearly indicates that Europeans are looking for debt assets outside home base in search of yield as they begin to save more.
We shy away from predicting where the yield curve goes from here. Instead, the goal of this piece is to understand why the yield curve is flattening, giving us intuition into what macro factors must change if the phenomenon is to reverse.
The main reason yield curve is flattening because short-term rates are rising while yields on the long end of the curve remain locked in a tight range, seemingly refusing to go much higher.
Since the Fed controls the short end of the curve, any step back from their current path of tightening – perhaps if economic growth slows and inflation slides lower – will probably reduce the pace of compression.
The more interesting question is what happens to long-term rates. Economists and investors have expected long-term rates to rise for several years now, but yields keep going the other way – a common explanation is that yields are already low and so they cannot go lower, but this reasoning is insufficient. Yields are likely to climb if there is an unexpected rise in inflation, or perhaps if Congress approves a large fiscal stimulus package (as was the expectation immediately after the U.S. presidential election). However, the Fed is also likely to increase their pace of tightening under this scenario, mitigating any steepening of the curve – similar to the late 1990s.
The answer to where long-term rates go may ultimately lie in how European demand for foreign safe assets change. As we discussed above, domestic consumption has collapsed across Europe since the crisis and the region has a surplus of savings – making it the world’s lender. Germany’s economy expanded 0.8% in the third quarter (2.8% year-over-year) – but 50% of the quarterly growth came from net exports while the rest was from inventory growth. Household consumption and fixed investment were flat. So the savings trend only seems to be continuing despite Europe’s improving economy.
Compounding the savings glut is that the fact that large portions of European yield curves are mired in negative territory and the aggregate amount of euro-denominated safe assets has shrunk significantly. These are a result of choices made by European policy-makers and in theory, can be reversed. Though it remains to be seen how soon that will happen, if at all.
Europe’s savings glut also raises the question as to whether it is putting the world on a crisis-path. We do note that the current situation is a different from the mid-aughts, when excess savings from countries like Germany and Netherlands funded reckless investments in other parts of Europe and the U.S. housing sector. We make no comment on whether European funding of foreign debt, especially U.S. debt – treasury and corporate – is a ‘reckless’ endeavor.
Nevertheless, as Klein notes in his recent FT piece , when one group of people begin to save a lot more than they used to, someone else is saving less. Saving less is fine if that means a country is investing in its productive capacity. However, that is not often the case and more typically, “ instead of being pulled to where they could do the most good, excess savers push themselves onto whomever they could “ , resulting in bubbles and subsequent crisis – like Latin America in the 1970s, East Asia in the 1990s, peripheral Europe, U.S. and U.K. in the 2000s.
The global imbalance that comes out of Europe’s savings glut may not create immediate problems but a crisis could result eventually. We will be paying close attention to this issue.Footnotes