• Trade tensions led financial news wires in recent weeks, particularly related to heightened rhetoric from the White House toward China
  • The Treasury curve flattened further in June, sparking fresh questions regarding the potential for curve inversion and the implications
  • The U.S. economy continues to progress, particularly relative to major competitors, but escalated trade tensions remain a near-term headwind

Trade tensions led the financial news wires for much of June amid heightened rhetoric between the United States and China. In the final two weeks of June, the Trump administration announced plans for more tariffs on Chinese products, with threats of additional tariffs if China retaliated. Additionally, the White House initially roiled markets on June 25 when reports surfaced that it may invoke emergency powers under an obscure 1977 law to restrict Chinese investment in U.S. companies (particularly the tech sector). Within 48 hours, the President backed down from this course of action amid strong internal disagreements, and President Trump decided instead to focus on building up the existing Committee on Foreign Investment, headed by Treasury Secretary Mnuchin. The committee would scrutinize foreign acquisition of U.S. companies and is considered a less confrontational approach. Nevertheless, anxiety in risk markets and economic circles has been elevated on concerns that these trade tensions may continue to worsen and spiral out of control. There are numerous examples of the negative consequences of global trade wars, most notorious being the economic fallout out of the Smoot-Hawley Tariff Act of 1930, after which U.S. exports declined 60% and the Great Depression deepened.

Milwaukee-based motorcycle manufacturer Harley-Davidson announced June 25 that it would not be passing on the cost of the European Union’s (EU) 25% tariff on its European consumers, instead choosing to eat the cost. The new tariffs are a retaliatory response to the White House’s new steel/aluminum tariffs, and the company sparked controversy when it also announced that it may shift some motorcycle production overseas to avoid/limit the impact of new tariffs in its second largest market. President Trump quickly responded via Twitter suggesting that Harley-Davidson will have “surrendered, they quit” if it moved any production overseas. The reaction in financial markets to recent trade rhetoric has been relatively muted thus far, but trade remains perhaps the greatest near-term risk to global growth and inflation.

Inverting Yield Curve?

The 2-year/10-year Treasury spread has narrowed in recent weeks to a new cycle low of 35 basis points (bps), and the 3-month/10-year spread is currently at 93 bps (also a current cycle low). Many questions have arisen in recent months as to whether the yield curve will invert in the coming months, an event that that has preceded each of the last five recessions. Some have also questioned the Fed’s intentions of continuing to tighten as the curve flattens. It’s important to note that yield curve flattening is the norm, not the exception, during tightening cycles, and the 1994-95 tightening cycle is the only one in modern history where a soft landing was achieved (i.e., no inverted yield curve). To be fair, even during that cycle the curve was far from steep, with a trough slope of 0.07% in late 1994. Nevertheless, multiple Fed leaders have addressed this issue in recent months, as discussed in last month’s Economic Overview.

While inverted yield curves have been present prior to past recessions, it’s difficult to prove causality. For example, during the last business cycle, the curve inverted in early 2006, 22 months before the impending recession began. The current domestic data trend remains robust. In fact, Markit U.S. Composite PMI eclipsed the country’s four biggest competitors in May for the first time in 18 months, and the May reading of 56.6 was the highest in the index’s 36-month history. In short, the U.S. economy has been pulling away from global competitors in recent months, particularly those in Europe. For depository institutions, deposit franchises have been increasing and interest margins expanding despite the flatter curve (higher asset yields; lagging deposit rates). Exhibit 1 provides the price to tangible book value ratio for the KBW Bank Index, which has risen to post-crisis highs in recent months.

One last point to consider when assessing yield curve slope and potential implications is the concept of term premiums. The yield on a nominal Treasury security (e.g., 10-year note) can be decomposed into the sum of the compounded expected future short-term interest rate over the maturity of a bond and a term premium to compensate investors for bearing the risk that short-term yields do not evolve as expected. Exhibit 2 observes historical term premiums for a 10-year zero coupon bond since 1990 as calculated by the Fed.

Term premiums have been negative for much of the last five years, which has coincided with unprecedented asset purchases by the word’s largest central banks. The purchase decisions of central banks are independent of valuation/risk metrics such as term premium, and when comparing current yield curve slope to prior cycles, it’s important to note that term premiums for long-term bonds are significantly below historical averages. As the Fed continues to reduce its bond portfolio, term premiums for long-term bonds should theoretically increase, which could offset some of the recent flattening pressure. That said, a flatter yield curve is very normal during a Fed tightening cycle, as discussed above.

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