Yield Curve Signals Pain Ahead
On a nonfarm payrolls day, and with equities looking awful on a long-term basis but well oversold on a short-term basis, Risk Watchdog is looking to the bond market for medium-term clues. Yields in the US and Germany have come down significantly over recent weeks, particularly at the long end. The immediate reason for this is risk aversion, as the market prices in our long-standing view that deflation will ultimately reign supreme.
US 10-Year Treasury Yield, %
But a closer look at the yield curve is disquieting, even to Risk Watchdog, as the US and German 2s-10s curves look set to come down considerably after being elevated for two years.
Germany Spread of 10 Over 2-Year Bunds (%)
Such a flattening could realistically occur under two scenarios. First, if central banks tighten rates, raising short-end yields, otherwise known as a bearish flattening. Or second, if short-end yields remain constant (and at 0.6% or so, 2-year yields have little room to fall), while the long end comes down considerably. Given my macro outlook (and that of my colleagues at Business Monitor), I think the second scenario is more likely by far. It would coincide with further significant equity downside, and perhaps even a cranking up of quantitative easing. Either way, it is a warning signal.
US Spread of 10 Over 2-Year Treasuries (%)