28 Jun 2018
Those making judgements around the inversion of the yield curve seem to be in a hurry to jump into one of two camps: the curve signals an impending recession. Or it doesn’t.
We need to be more nuanced than that.
For the record, ANZ Research doesn’t think the US will have a recession. But for that to be correct, the US Federal Reserve needs to respect the yield curve – as it did last year. When the Fed was hiking its key interest rate, it kept signalling hikes well in excess of bond market pricing; and it showed confidence about that view. But as the curve flattened and the US economy began to slow, the Fed quickly changed its view. It moved to a firmly neutral stance in February.
"If the curve continues to flatten, another shift in Fed stance may eventually be warranted.”
If the curve continues to flatten, another shift in the Fed’s stance may eventually be warranted.
It is likely that part of the recent, surprising, flattening in the curve represents the last relics of the deflationary effects of 2018’s sharp oil price fall.
Certainly the last time so many central banks became more dovish in a short span of time was in the wake of the sharp decline in oil prices in 2015.
As well, ANZ Research expects an improvement in the technology cycle over the next quarter or so to help improve some of the concerns about global growth.
Both these factors could steepen the curve enough to take any inversion away although it would still leave the curve very flat. Regardless of the apparent fundamental health of US economy, that would be a worry.
The yield curve leads US credit growth. The lags are not always reliable but every flattening in the curve in the past three decades has ultimately been associated with a sharp slowdown in bank lending.
Bank lending is the lifeblood of any modern economy. Australia, China and Korea, among others, are rediscovering this as they seek to cap growth in lending.
In ANZ Research’s view, one of the main implications of a flatter curve is it reduces the gains available to entities that engage in maturity transformation, namely banks, other financial institutions and many investors. Why the curve is flattening – which is typically where most of the analytical effort on this issue is applied – probably doesn’t affect this conclusion all that much.
The US Federal Reserve’s latest Senior Loan Officer Opinion Survey (SLOS) reported unchanged lending standards in the final quarter of 2018. This is a sharp shift from quarter three when lending standards were easing.
In fact, the shift towards tighter lending standards is the sharpest quarterly adjustment since the global financial crisis.
Significantly, it’s not whether bank lending standards are tightening or easing that correlates with bank lending growth but the direction in which lending standards are moving.
The shift to unchanged standards is consistent with slower bank lending as well as wider credit spreads. And, importantly, while the lags between the curve and bank lending are varied, the lags between lending standards and lending are not. Lending standards are a very timely signal of credit supply.
Last quarter the tightening in lending standards wasn’t just administrative; lending spreads (over banks’ cost of funds) widened in the quarter. In fact this was the first quarter since the financial crisis that banks, on balance, increased spreads to customers.
Each quarter, the Fed also gives a summary of both the mechanics and the reasons for the shift in lending standards. Banks last year were easing standards primarily via reduced spreads and they did so because of increased competition (from banks and nonbank lenders) and a more favourable economic outlook. The shift to unchanged standards in the latest quarter, though, reflects a more uncertain economic outlook as the main reason.
If, since the Fed last surveyed the banks in Q4, growth has continued to slow and the curve to flatten, there seems to be a reasonable prospect the next reading on lending standards will show further tightening.
In fact, in the Q3 2018 SLOS, banks were asked an ad-hoc question on how their lending policies would potentially change in response to a hypothetical moderate inversion of the yield curve prevailing over the next year.
“Significant shares of banks indicated that they would tighten their standards or price terms across every major loan category if the yield curve were to invert,” the SLOS report found.
The bottom line is that, if the curve continues to surprise us and flattens further or even just stays around zero, the Fed may well need to become more responsive to the economy.
If the Fed doesn’t act, the risk is that it may walk the economy into the recession that didn’t need to happen.
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.
28 Jun 2018
29 Jun 2018