Yield Curve Flattening Spooks Markets

The spread between 3- and 5-year yields fell to -0.7 bps on Monday, dropping below zero for the first time in more than a decade.

This has taken place as the Fed turns more cautious and has led to short covering driven buying in the mid- to long-end of the treasury curve, while short term rates have held steady. The flattening accelerated a sense of panic in the equity market that was exacerbated by Trump’s tweeting that he is a “tariff man.” Falling semiconductor prices also added to market woes.

Inversion - where yields at the short end rise above those at the long end - has been one of the indicator of recessions (not always). However, Citi analysts see little reason to panic. The 2-year yield was above the 10-year yield for most of 2006 and much of 2007 before recession in 2008-2009. The fed funds rate itself was above 10-year yields for 6 quarters.

US economic data do not confirm higher risk of near-term US recession: ISM manufacturing bounced back due to a substantial increase in new orders. This should help support strong US activity over the next few quarters. The Eurozone composite PMI declined again in November due to export headwinds and is consistent with ~0.25%QQ GDP growth, but German factory orders are starting to recover.

On the trade front, China has announced a comprehensive crackdown on intellectual property theft, coordinated across 38 ministries and departments. More follow ups also came on tariff reductions on US autos. The quick follow-ups suggest that preparations were made well ahead of the G20 meeting. As such, Citi analysts continue to believe that the odds of a trade deal have risen, while Trump’s tweets likely aim to keep pressure on China to ensure these progress.