Macro Insights Weekly: Making sense of flattening curves

We examine the drivers of the sudden flattening of the yield curve over the past month.
Taimur Baig, Radhika Rao19 Jul 2021
  • The market doesn’t want to fight the Fed in the earlier-than-previously-envisaged lift-off narrative
  • But it is not convinced at all that growth and inflation are going to be higher in the long-term
  • Short-term inflation markers are high, with strong demand meeting tight supply
  • Long-term inflation markers are subdued, as the chance of structurally higher productivity, wages…
  • … and prices is subject to pipeline legislative developments and economic dynamics
Photo credit: Unsplash

Commentary: Making sense of the ongoing flattening of yield curves

Recent weeks have been characterised by strong US data, ranging from home sales to wage growth. Most strikingly, prices are rising, beating expectations. Last week, the US Bureau of Labor Statistics reported that consumer prices had risen by 5.4% over the past year, the fastest since August 2008. Also, the latest producer prices for final demand was up by 7.3% over the past year, the fastest since November 2010.

Monetary policy officials may consider the price developments transitory, but they are not ignoring the data entirely. The US Federal Reserve’s shift in tone came last month, both with respect to growth and inflation, with most FOMC members bringing forward their time horizon of policy lift-off.

And yet, the US fixed income market’s response to the data and policy developments has been rather extraordinary, with the yield curve flattening over the past month. Why are short-term rates up a tad and long-term rates down a lot? We think there are two major factors at play:

Growth upside largely priced in

Firstly, the narrative of (i) economic re-opening, (ii) pent-up demand being released, manifesting in higher prices, and (iii) some supply side crunch to continue for a while, is firmly on the radar of investors and well incorporated in the price of equities, houses, and other assets. This applies to both China and the US, and has been the case for most part of this year as vaccination began in earnest. Strong retail sales or jumps in housing prices data are therefore not surprising, rather expected. As expectations have become heightened, positive data surprises have all but disappeared.

Inflation hawks are not persuading markets, at least not yet

Global shipping freight rates have soared, as have air freight rates, along with food, energy, metals and building materials. Rents have risen, wages are rising, prices of cars are rising due to a paucity of semiconductor chips, and services prices are beginning to firm up as well, in response to strong demand. Consequently, inflation expectations, after plummeting last year, have recovered, going well past 2% in the US.

But recovery from the depth of the Covid crisis is one thing, hitting highs that can cause markets and central banker to take alarm is an entirely different thing. Since the rebound in expectations began, alongside a rise in actual reported inflation, there has only been trend-reversion, as per market-based indicators.

Despite recent developments, long-term inflation expectations, both in the US and EU, remain well below their levels 5 years ago. As commodity and other prices have soared, the debate on the near-term inflation outlook has ceased to matter; even US Fed and Treasury officials readily concede that above-trend inflation is here to stay for a few quarters. Especially in the US, with levels of nominal and real GDP likely to make up this year the losses due to last year’s recession, Fed officials are increasingly of the view that the time to begin removing the extraordinary accommodation in place is getting closer. This feeds directly into higher short-term rates.

But for the curves to steepen in a meaningful manner, a lift-off in productivity, return on capital, wages, and prices would be warranted. The way the fiscal agenda is shaping up in the US and EU, with record investments in infrastructure and social spending likely in the coming years, these expectations could very well come to fruition, but that would have to depend on landmark legislative achievements and favourable economic dynamics. The market is yet to embrace this scenario.

Concrete expectations over the short-term bullishness and substantial uncertainty over long-run prospects explain the recent curve flattening, in our view. A passage of a multi-trillion dollar infrastructure package could be the first salvo toward curve steepening.

To read the full report, click here to Download the PDF.

Taimur Baig, Ph.D. 泰穆爾 貝格, Ph.D.

Chief Economist - G3 & Asia 集團首席經濟學家 - G3 及亞洲

Radhika Rao

Economist – India, Indonesia, Thailand & Eurozone

Subscribe here to receive our economics & macro strategy materials.
To unsubscribe, please click here.
The information herein is published by DBS Bank Ltd. It is based on information obtained from sources believed to be reliable, but the Group does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation & the particular needs of any specific addressee. The information herein is published for the information of addressees only & is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Group, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Group or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Group & its associates, their directors, officers and/or employees may have positions or other interests in, & may effect transactions in securities mentioned herein & may also perform or seek to perform broking, investment banking & other banking or finan­cial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Sources for all charts & tables are CEIC & Bloomberg unless otherwise specified.

DBS Bank Ltd., 12 Marina Blvd, Marina Bay Financial Center Tower 3, Singapore 018982. Tel: 65-6878-8888. Company Registration No. 196800306E. DBS Bank Ltd., Hong Kong SAR Branch, a company incorporated in Singapore with limited liability. 18th Floor, The Center, 99 Queen’s Road Central, Central, Hong Kong SAR.

The information set out in this website ("Information") is not directed to, or intended for distribution to or use by, any person or entity that is a citizen or resident of or located in any locality, state, country, or other jurisdiction (including but not limited to citizens or residents of the United States of America) where such distribution, publication, availability or use would be contrary to law or regulation. This Information is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction (including but not limited to the United States of America) where such an offer or solicitation would be contrary to law or regulation. This Information is published for general circulation only and does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person. Visitors accessing this website should always seek advice from an independent financial adviser regarding the suitability of the Information referred to herein (taking into account the specific investment objectives, financial situation and/or particular needs of each person in receipt of the Information) before making any investment and/or any purchase in reliance of the Information. Please refer to the actual research publications for important disclaimers and disclosures, where applicable.