Over the weekend, we presented an analysis by Citi looking at how long after the yield curve inverts do investors have before they should start worrying. As Citi's Jeremy Hale noted, "sometimes inversion provides a timely signal for the economic cycle a la 2000, where Professor Curve predicted almost the ding-dong high in the SPX. However the 2006 episode of inversion dished up 7 months of pain for equity bears, with 18% further upside for the SPX. Ditto for the 1989 episode where equities continued to rally 22% into the 1990 recession (Figure 3, RHS). For now, we’re comfortable with the flattening dynamic with regards to other markets but would become increasingly cautious as the curve approaches zero."
Which leads to the next logical question: how long before the current 60bps or so spread in the 2s10s drops to 0, and then inverts?
Today, in its 2018 Global Strategy Outlook, Morgan Stanley provided its answer: the yield curve will be "completely flat" in roughly 10 months, or by September 2010.
As rates strategist Matthew Hornbach writes, previewing his bear flattening base case "the highlight of our global rates year-ahead outlook is the flattening of the US Treasury curve." He explains that the bank's economists project that the Fed will continue to remove policy accommodation gradually by increasing the target rate range at each quarterly press conference meeting until it reaches 2.00-2.25% in September 2018. Meanwhile, as the Fed raises rates gradually, the curve will continue to gradual flatten such that, "in 3Q18, all Treasury yields will be in the lower end of that 2.00-2.25% range."
According to Hornbach, the forecast for a completely flat curve is based on two key: i) Global central bank balance sheets continuing to grow in 2018; and ii) The Fed continuing to tighten monetary policy both via short-term rates and, increasingly, its balance sheet in an environment of low realized inflation.
Also of note, Morgan Stanley predicts that the Fed's balance sheet normalization will no longer result in a sell off in the long end, as the "upward pressure on term premiums and steepening pressure on the yield curve from the Fed's balance sheet normalization occurred in late 2016 and early 2017. As a result, we no longer see the balance sheet as a threat to higher yields and steeper curves. We also believe that the market is already pricing in the increased Treasury supply from the tax reform package we expect in 2018."
As Cross-asset strategist Andrew Sheets adds, while "the yield level at which we think the US curve goes flat would be unusual" the trend of a flatter curve isn't, and would be highly consistent with the Fed tightening in a late-cycle environment.
Furthermore, the MS forecast is economy independent: on one hand, "if growth is better than expected, we think short-end rates rise more" resulting in a bear flattener, while on the other, "if growth weakens more, or sooner, we expect strong demand for US duration, given its high real yield" leading to a bull flattening which marked much of 2016.
Additionally, when looking at all various factors that go into Treasury yields - implied policy rates, inflation compensation, and the term premium - they all result in curve flattening, according to the bank.
It is also worth noting that Hornbach's forecast "includes a large decline in 30y Treasury yields." As of today, the bank expects the 30y to end the year below 2%, which would send it to the lowest level observed since the financial crisis. In fact it would be a record low. This was not an easy recommendation to make. As Andrew Sheets discloses, when making the bank's forecast, "the sharpest debate was over our US Treasury forecasts, which are, by any measure, aggressive. We are forecasting global growth to rise by 0.2pp versus 2017, G10 inflation to move higher and the Fed to hike three times next year. Yet we have US 30-year rates hitting an all-data low of 2%, below the lowest levels seen in the GFC, the eurozone crisis or the height of enthusiasm for 'secular stagnation'. It was also noted that these prior lows had occurred with the benefit of QE, which is now being unwound and, in theory, should raise term premiums."
As Bloomberg observes, this won't be the first time Hornbach has made an outlier call.
In the third quarter of 2016, he predicted the 10-year yield would hit 1 percent in the first quarter of 2017. Ten-year yields never traded within 130 basis points of that level during the first three months of this year, as Donald Trump’s surprise victory in the presidential election spurred speculation that expansive fiscal policy would stoke growth and inflation.
Hornbach's conclusion: "Whether we look at the curve via term premium or via rate expectations, we come to the same conclusion: the yield curve will continue to flatten."
Of course, this also means that some time in the third quarter, absent a major change in monetary policy, the curve will also invert. What happens then? Well, as Morgan Stanley's economists note, while “we are not on recession watch now, and peg the 12-month probability of recession at 25%, by 2020, that probability grows to near certainty.”