Normal yield curve doesn’t mean everything’s normal

As we count down to this month’s meetings of the European Central Bank and the Federal Reserve, both of which are expected to maintain their monetary easing stance, the US yield curve has been quietly undoing the inversion that had raised alarms in the corridors of the world’s two most systemically important central banks.
Over the last few weeks, the US yield curve has been slowly and gradually regaining its more traditional upwardly sloping shape whereby longer maturity bonds trade at a higher level than their shorter-maturity peers. On the most-watched segment of the cure, the so-called 2’s-10’s, the benchmark 10-year Treasury traded at 1.75% at the market close on October 25, or 17 basis points above the yield on the two-year note. The curve for the 10-year bond and the three-month Treasury bill has also reverted to normal, though several of the intervening segments remain inverted for now.
It is hard to argue that the continuing normalisation has been driven by an improvement in economic indicators. If anything, these have worsened, including last week’s surprising drop in retail sales, raising concerns about household consumption, which has been the most robust part of the US economy. Moreover, the worsening of indicators has been even more pronounced internationally, particularly in China and Europe. It’s no wonder the International Monetary Fund, among others, revised down its projection for global economic growth to the lowest level since the global financial crisis. I worry that even these latest revisions may not be enough to capture the drag from the slowdown in Europe and elsewhere in the world. A better explanation
for the restoration of the US yield curve can be found in the evolving market perceptions of future central bank policies, in the US and abroad.
Despite the weak global economic outlook, a growing set of signals has been coming out of central banks suggesting waning enthusiasm and appetite for the continued use of unconventional measures such as negative interest rates and large-scale bond purchases. Such easing is viewed as having limited, if any, sustainable benefits for economic activity.
It was unwise to react to the inversion of the Treasury yield curve with extreme anxiety about a US recession, it would be premature to celebrate the recent partial reversion as an indicator of significant strengthening of US economic prospects. Instead, both are reminders of the extent to which traditional economic signals have been distorted by a prolonged period of extraordinary central bank policies. And they should also been seen as just one of the unusual consequences of a monetary stance that, imposed for several years on central banks by the lack of proper policy action elsewhere, will now see the hoped-for benefits give way to a broadening and deepening recognition of the unintended
consequences and collateral risks.

—Bloomberg