Grant's Interest Rate Observer

Rate Rout: An Inverted Yield Curve on the Way?

Behold, the incredible disappearing yield curve. Around the world, inflationary metrics are suddenly percolating, sending short maturity government borrowing costs upward.  At the same time, long yields have generally held steady or even declined.  

 

Consider recent data from Japan, which on Sunday reported a 3.4% year-over-year increase in producer price inflation (PPI) in October, to bring the 2017 average to a gain of 2.1%.  That continues a stark upside reversal, vs. a year-over-year reading of negative-2.6% in October of last year, and an average of negative-3.2% for 2016 in aggregate.  Consumer prices, while moving at a far less dramatic pace, have also turned clearly upward. Japanese CPI for October gained 0.7% year-over-year, matching the September reading for the highest since early 2015. 

 

In the United Kingdom, this morning’s release of October consumer price inflation showed a 3.0% year-over-year uptick, maintaining September’s level at the hottest pace since early 2012.  A reading of 3.1% or above would have compelled Bank of England governor Mark Carney to pen an open letter to the Chancellor of the Exchequer Philip Hammond to explain, according to the BoE website:  “The reasons why inflation has increased . . . to such an extent and what the Bank proposes to do to ensure inflation comes back to the [2%] target.” 

 

Stateside, this morning’s release of October PPI showed more of the same: Higher prices.  The headline 2.8% year-over-year jump was the highest since February of 2012.   While that figure is burnished by a 20% year-over-year rise in gasoline futures, the PPI ex-food and energy firmly maintained that plain upward trajectory with a 2.4% year-over-year advance in October.  Strip out food and energy prices, and PPI has risen by an average of just over 1.8% through the first 10 months of the year, compared to average increases of 1.2% and 0.8% in 2016 and 2015, respectively. 

 

With that synchronized uptick in measured prices comes a synchronized compression in government yield curves. While the Bank of Japan-dominated JGB market has sported a pancake-flat yield curve for some time, the U.S. and U.K. had as recently as 2014 both offered an additional 200 basis points of annual income for those willing to lend for 10 years versus two. Spreads are now converging it seems

 

Meanwhile, a similar surge in Chinese borrowing costs has pushed its five-year yield to 4.01%, above the 10-year yield of 3.99%). For the world’s second largest economy and leveraged lynchpin of many a bullish hope, a flattening yield curve could be a warning sign (Chinese five-and 10 year yields also briefly inverted earlier this year, to little apparent effect). 

 

In the U.S. at least, yields on the two-year note last exceeded the 10-year yield in early 2000 and in late 2006. In each instance, recession and substantial asset price markdowns followed in due course.  Writing on Nov. 17, 2006 (“Intercontinental tightening push”) amidst a prolonged tightening cycle in which Fed Chairman Ben Bernanke raised the overnight lending rate to a now-hard to fathom 5.25% in July of that year, Grant’s hazarded a guess over the coming direction in rates:

 

Where will it all end? With a falling fed funds rate and a rising Japanese overnight rate, we predict. The U.S. auto and housing industries cry out for interest-rate relief, and the Japanese policy rate could hardly go much lower. No interest rate forecast is not reckless. Ours may be the least reckless of the season.

 

We will grade that prediction at one-out-of-two, which would either get you failed out of school or a fast-track induction into the baseball hall of fame in Cooperstown, N.Y., depending on your preferred metaphor. As for today, that inverted yield curve scenario is still a hypothetical one.  It is becoming gradually less so.