UST Curve: the next flattening leg
30 Oct 2015
Economics
UST Curve: the next flattening leg
DBS Group Research
30 October 2015
• The flattening in the 5Y/10Y segment has been driven by falling inflation expectations
• Fed normalization should drive further flattening
• If global growth falls further, even more flattening would occur
Rates have been stuck in limbo for several quarters as the market oscillates between expectations of Fed normalization and worries of slower global growth.
Depending on which issue dominates, the 5Y/10Y UST spread has hovered between 60-75bps since early May. Following the October FOMC, spread compression took place as Fed liftoff dominated easing China growth concerns.
We believe that further spread compression can occur over the medium term.
Whether flattening is bull or bear will depend on how the global economy
pans out.
Under our core scenario, bear flattening is likely to occur as Fed normalization
takes place amid a low inflation environment. Through the 2004-2006 Fed hike
cycle, the 5Y/10Y spread narrowed by 100bps in the span of two years (20042005). Significant compression has already taken place in the current cycle but
this has come largely on the back of adjustments in inflation expectations that
brought 10Y UST yields lower in 2014/15.
Going forward, curve flattening seems likely to be driven by rising 5Y yields.
The market appears to be underestimating the pace of Fed tightening. Any
hawkish signal from the Fed would likely have more of an impact on 2Y-5Y
UST Curve - 5Y/10Y spread
bps
200
Fed taper
heading into
liftoff
2004/06 Fed
hike cycle
150
100
50
0
-50
Jan-00
Jan-02
Jan-04
Jan-06
Jan-08
Jan-10
Jan-12
Jan-14
Jan-16
Jan-18
Eugene Leow • (65) 6878-2842 • [email protected]
1
UST Curve: the next flattening leg
WTI crude prices & inflation expectations
USD/bbl
65
WTI crude (lhs)
60
55
50
45
40
35
30
Jan-15
US 5Y inflation swap,
5Y forward (rhs)
JGB Curve - 5Y/10Y spread
%
bps
2.50
100
2.45
90
2.40
80
2.35
70
2.30
60
2.25
50
2.20
40
2.15
30
2.10
20
2.05
10
2.00
Apr-15
Jul-15
Oct-15
30 Oct 2015
0
Jan-10
More QE
upcoming?
QE expanded
over the past
few years
Jan-12
Jan-14
Jan-16
yields, compared to longer-term yields. Moreover, long-term UST yields continue to be held down by the persistent decline in commodity prices and low
wage growth. Barring a sharp turnaround in inflation expectations, upward
pressure on 10Y yields is likely to be restrained.
If global growth stagnates, look to the JGB curve
If the global economy stagnates, bull flattening is a plausible scenario. Japan’s
experience from 2011-present is instructive. Over this period, the 5Y/10Y JGB
spread fell from 88bps to 26bps as GDP growth averaged 0.7%. As growth faltered, the Bank of Japan (BOJ) embarked on multiple rounds of quantitative
easing with speculation of more to come in the coming months.
A similar development could take place in the US. Strains in emerging markets
and China could place a drag on US growth while putting further downward
pressure on commodity prices. This combination could spark speculation of further quantitative easing from the Fed while dashing inflation expectations.
Under such a scenario, term premiums would likely fall, further flattening the
5Y/10Y segment of the UST curve.
Sources:
All data are sourced from CEIC Data and Bloomberg. Transformations and forecasts are DBS Group Research.
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UST Curve: the next flattening leg
30 Oct 2015
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