The Tell: Tax-cut plans might be more to blame for flat yield curve than investors think
Traders and analysts say the Federal Reserve’s intent to raise interest rates in the face of subdued inflation is the driving force behind a flattening of the yield curve that’s alarmed some investors in the past few weeks, but one analyst argues otherwise.
Jim Vogel, interest-rate strategist at FTN Financial, said market participants are overlooking the importance of proposed tax cuts while making too much of the central bank’s role in driving the phenomenon.
“Curve flattening can become further detached from the Fed rate increase outlook even more than it has been this month,” Vogel said.
Read: Why the yield curve may invert even if the Fed sees inflation pick up
The yield curve is a line plotting the yields across Treasury maturities from the shortest dated to the longest, and can reflect investor expectations for growth and inflation. A flatter curve is seen as a sign investors are worried about growth. If its flattens enough it can result in a so-called inversion, where short-term debt carries a higher yield than longer-dated paper, a phenomenon that has preceded the last seven recessions. Yields and debt prices move in opposite directions.
The curve isn’t yet inverted, but many analysts argue that it is likely to happen as the Fed continues down the tightening path.
See: Why this U.S. recession signal is probably throwing off a false alarm
Vogel notes, however, that the Treasury Department , at its quarterly refunding announcement earlier this month, said it would lean toward short-dated paper as it funds itself in coming months. Specifically, the Treasury Department said it would issue more 2-year and 5-year notes. That’s provided some relief to holders of long-dated government paper, but punished short-dated debtholders.
Meanwhile, analysts say the government will have to ramp up issuance to make up for the Federal Reserve’s quantitative tightening as well as the potential rise in the deficit that would accompany the tax plan.
The Federal Reserve in October began the long-awaited process of shrinking its balance sheet, slowly paring back the amount it reinvests as the debt it stockpiled during various iterations of quantitative easing matures.
As measured by the spread between the 2-year note TMUBMUSD10Y, -0.34% and the 10-year note TMUBMUSD10Y, -0.34% , the yield curve flattened 11 basis points last week to 0.62 percentage point, the tightest since November 2007 (see chart below).
Read: Yield curve ends week flattest in a decade
The flattening has coincided with the Republican efforts to pass a $ 1.4 trillion tax cut. House Republicans passed their version of the tax bill on Thursday. The Senate faces a difficult vote on its version of the plan when lawmakers return next week. Analysts at Goldman Sachs upped the chance of the tax overhaul being written into law to 80% by early 2018, from an initial estimate of 65%.
Vogel highlighted another way the prospect of a comprehensive tax cut could contribute to the curve flattening. With the initial impact of the cut front-loaded, the boost to growth and inflation would be seen mostly between 2019 and 2023. The inflationary impact would, therefore, hurt maturities at the short-end of the curve, pushing yields higher, whereas the long-end would stay relatively unchanged. If the tax plan is weighted more toward households, he said, the maximum economic effects would be felt in 2018-2020.
But traders are bumping into problems predicting what the fallout of a successful tax bill, and even its potential failure, might look like. For example, if the Republicans fail to overhaul the U.S. tax code it’s not clear if the bond market would rebound as the GOP would have no choice but to go back to the drawing board in early 2019, keeping the threat of an inflationary tax plan alive.
“The difficulty of trading either politics and the unknown repercussions of the first major tax bill in three decades helps to explain why Treasury [trading] volume has been sporadic this month,” he said.