Fed considers doing the twist again

US yield curve flattest for more than a decade

The long end of the US yield curve is at its flattest for more than a decade, risking distortions in the economy as the Federal Reserve raises rates.


The shape of the US Treasury yield curve is often referenced as an indicator of the perceived health of the economy, which in turn has global implications. Investors generally focus on the two-year versus 10-year yield curve, because this is regarded as an indicator of future recessions if it falls below zero. However, Legal & General Investment Management finds the 10-year versus the 30-year slope just as interesting.


The latter is now at its flattest since June 2007. This is particularly important because most US mortgages reference the 30-year point, particularly as adjustable-rate mortgages have fallen to just 15% of the total. If the Fed wants to tighten financial conditions for consumers, to meet its dual mandate of stable prices and maximum employment, higher 30-year interest rates play a key role.


So why has the curve become so flat – and is this a sign of impending doom? On the second question, well, no, we don’t think so. The good news is that there are temporary and structural factors that are pushing down on long-end rates. On the temporary side, US tax cuts make it very attractive for companies to put money into pension schemes before September 2018, which then feeds into the structural trend of US pension schemes derisking, whereby they buy more long-dated bonds as their funding levels improve.


But the bad news for the Fed is that this flattening makes it hard for the central bank to tighten monetary conditions for consumers. Unless policy-makers react, to achieve a certain level of cooling of the economy, the effects could be very uneven. To compensate for the lack of impact on most mortgages, they will need to do more elsewhere, at the short end of the yield curve. That could require excessive tightening on some parts of the economy (those affected by shorter-term rates) and also on international financial conditions – in particular emerging markets, whose corporates borrow a lot in dollars and at US interest rates.


What is perhaps surprising, given the issues outlined above, is that part of the flattening is the Fed’s own fault. In September 2011, it launched Operation Twist, a homage to Chubby Checker’s smash hit, from when a similar policy was employed in 1961. Under the policy, which ran until December 2012, the Fed bought $667bn of longer-dated bonds with terms from six to 30 years, replacing bonds with terms below three years. The Fed did this to flatten the curve deliberately as it sought to help longer-dated borrowing. If the Fed twisted the yield curve again, it could sell longer-dated bonds in exchange for shorter-dated ones and release the pressure on the long end of the curve, helping ensure a balanced tightening of monetary policy.


Even mentioning such a strategy would be risky for the Fed. It could cause a violent reaction in long-dated rates, making the barriers to such a move high. There is currently very little coverage of this as a policy option, but it will probably become more mainstream and a risk to long-dated US bonds if the flattening continues.


John Roe is Head of Multi-Asset Funds at Legal & General Investment Management. This article first appeared on the LGIM Macromatters blog.

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