18 Jan 2018
The focus on the US yield curve has increased recently – something which doesn’t happen very often.
The curve normally slopes upward but at the moment it is almost flat. That’s rare.
"If the curve is very flat, as it is now, then lending to the most creditworthy borrowers makes little sense.”
However, it could be worse. The curve could tilt further so longer-term rates are lower than shorter term. Such an inverted curve has often preceded recessions.
While ANZ Research expects US growth to slow over the next couple of years when the Fed hikes and capacity constraints bite, this doesn’t mean a recession is expected.
Many commentators seem to be finding idiosyncratic reasons to explain the flattening in the curve.
In particular, the Fed’s quantitive-easing program reduced the supply of bonds in the market, flattening the curve.
Although the yield curve is not infallible by any means, historical record suggests there is no other economic indicator in which there should be more confidence.
An inverted curve would be a poor signal, so let’s not waste time on the why. Rather let’s look more closely at what it being flat means.
What ANZ Research is worried about is what a flat curve means for lending growth. At the end of the day, credit growth and economic growth are inextricably linked.
The slope of the curve indicates the return from “maturity transformation”.
When a bank lends money or an investor buys a corporate bond they judge whether they are receiving appropriate compensation to take a liquid cash deposit and lock it up for some period of time.
This maturity transformation is the whole reason modern economies can fund long duration investment, making them prosperous.
The key is the compensation for this risk.
If the curve is very flat, as it is now, then lending to the most creditworthy borrowers makes little sense. Owning their equity makes much more sense.
As well as slowing lending, credit providers will tend to go down the credit curve looking for return. That is, they will be taking more credit risk –behaviour ANZ Research has seen in recent years.
Since early 2011, US banks have eased lending standards in 22 of the 29 quarters – 75 per cent of the time.
Recent data show the proportion of US loans with a rating of single B or below rose from 25 per cent in 2007 to 65 per cent in 2017. The same data show 75 per cent of all 2017 institutional loans were “covenant lite” – very low security - the highest share on record.
Moody’s Covenant Quality Index has been almost continuously below Moody’s minimum protection threshold since 2014.
In this context, the flatter curve may not be indicating much about the risk of a recession in the short term, but it has put a spotlight on lending growth.
Commercial and industrial lending growth in the US has slowed from a peak of 12 per cent in 2015 to a low of 0.5 per cent last year.
This is a puzzle to many, but is entirely consistent with the flattening in the curve over the past few years.
And herein lies the crux: credit growth is the lifeblood of any modern economy.
Almost every economy which has experienced a secular slowdown in credit growth post-crisis – whether it is because of regulation, macroprudential policy or bad debts - has also seen a secular slowdown in economic growth.
Whether this slowdown occurs because of regulation or other drivers, such as the curve, seems to be largely immaterial.
More heavily regulated financial systems are more prudent - but they cost gross domestic product (GDP) growth.
This is also a key reason economies haven’t sprung out of growth slowdowns in the post-crisis period.
In previous cycles, the trick was to convince borrowers the worst of the cycle had been seen. They would then come back to the credit tap and this would generate a rapid period of growth after the slowdown. Yet over the past decade very few economies have shown much spring at all.
A period of recovery in lending growth, as seems to be occurring, should only be greeted with a one-handed clap. The recovery will probably only occur when banks and other lenders have eased lending standards even further.
With a flat yield curve, a pick-up in lending growth is likely to go hand-in-hand with rising systemic credit risk.
An extended period of easing lending standards also occurred in the late-1990s/early-2000s.
That easing extended the growth cycle; but it forced policy settings to respond in a way which ultimately set the scene for the crisis.
While commentary around why the yield curve is flattening will no doubt persist, it’s pretty academic why. The worry is it is.
Richard Yetsenga is chief economist at ANZ.
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
18 Jan 2018
12 Jun 2018