Yield curve flattening unleashes blow to Fed hike hype

US equity markets are gradually confronting the reality that a 2015 Fed hike is not feasible after US durable goods orders tumbled 3.4% in December after a 2.1%, undershooting expectations of a 0.3% rise. The 11.6% increase in December new home sales was not enough to reverse the market sell-off, which was initiated by disappointing earnings from Caterpillar (-7.1%) and Microsoft (-9.6%) due to slowing global growth and negative impact from the strong US dollar.

The Dow Jones Industrials Index fell by more than 2%, posting its biggest decline since October. Yields resumed their selloff, further boosting our forecast– held since December–that the Fed will stand pat in 2015.

Beware of prolonged yield curve flattening

The US yield curve as measured by the spread between the ten and two year yields or that of the ten and five year yields, has narrowed by 30 basis points (for 10-2 spread) since December 18. Such a rapid flattening of the curve in just over five weeks could imply that an inverted or negative curve could be here by late February.

Yield curve flattening explained

Inverted yield curves usually signal economic slowdowns and are often a harbinger of recession. The negative slope of the yield curve shows that short term yields are higher than long-term yields as bond traders expect lower interest rates ahead. Historically, yield curve inversions have started about 12 to 18 months before a recession. One main reason inverted yield curves have presaged economic weakness is that they narrow the premium gained by banks between the short-term interest rates paid out to depositors and the longer-term interest rates earned on loans.

On the long end of the curve, bond traders no longer price the chance of rising inflation due to their anticipation of slower growth ahead. The role of the flat yield curve in signalling a slowdown was especially powerful in this example as it was clearly at odds with the record highs in US equity indices in May 2007. Equity investors were largely misled when the economy slowed later in the year and the Fed was forced to cut rates three months later. The chart shows how the curve inversion of January 2007, when short-term rates were too high relative to the bond markets’ forward looking interest rate outlook as seen farther down the curve.

What we said in March 2014 about flattening curves & the stock market

“… traders will need to watch the overall shape of the US yield curve, for any curve flattening will escalate fears of another recession and the next real market crash. The good news is that we are at least 6-9 months away from such day of reckoning, and any 5-7% selloffs in equities aren’t likely to extend beyond that for now”

Not nine, but ten months later, the yield curve is at its flattest since 2009 and equity markets have entered the cycle of lower highs among escalating worries of disinflation and the inability for the US to handle any rate hike ahead.

As we head into Wednesday’s FOMC statement, the odds of a dovish turn statement have increased markedly, especially with a likely mention of the negative impact from a rising US dollar. Remember how the Dow rose 274 points on January 8 as the Fed minutes revealed worries about the impact of a rising USD on US companies.

An extremely dovish turn will serve up the classic effect of rising equities and rising yen crosses, with the exception of the USDJPY, but euro bears will remain on the look-out for fresh selling near 1.1650.