Treasury Yield Curve Has to Normalize Eventually

Thinking about the Treasury yield curve the night before the May ’23 nonfarm payroll report, eventually, the Treasury yield curve has to return to a positive slope, meaning that short-maturity yields are below longer maturity yields, and Treasury note and bond investors can “ride the yield curve” so to speak, which means that investors can buy 5 – 7 year Treasury notes and just hold them to maturity and as they become shorter maturities, the notes increase in price.

Nothing about Friday morning’s May ’23 nonfarm payroll report indicates that it would be a weak report, in fact, the ADP report and the jobless claims as well as the recent JOLTS report, have probably led investors to conclude that the probability of a stronger nonfarm payroll report for May ’23 –  above the 200,000 new jobs created – is in fact quite high. The payroll report could be well in excess of 200,000 net new jobs created.

But I can’t help but think that in the next month or two, we could start seeing weaker numbers.

Manufacturing has been weakening for a while, but what CNBC and the financial media don’t really tell you is that manufacturing is not really that big a part of the US economy anymore, maybe 10% of private sector GDP every year, and that’s probably generous.

It’s services that matter today and have mattered since 1990, and those services account for the lion’s share of private sector GDP, and services have not seemed to be impacted yet by the 500 bp increase in the fed funds rate.

But that will change too.

Writing to a client the other day, I told him the yield curve inversion or distortion is the equivalent of a bull elephant sitting on your chest, particularly for the financial sector. With the fed funds at 5% – 5.25% and the 10-year Treasury yield at 3.60%, it’s like someone twisting your arm behind your back and continually increasing the pressure.

JP Morgan and Goldman Sachs have announced small layoffs, and that’s due to weak capital market activity: Bond Buyer, which is a pretty good newspaper primarily covering municipal bonds, noted that May ’23 issuance volume declined 29%, versus last year. No doubt, once the Fed started raising rates in ’22, a lot of issuances was rushed to market.

However, corporate credit has held up well: as of May 31, ’23: both corporate high-yield and corporate high-grade asset classes were outperforming the other bond asset classes YTD, with returns of 3.64% and 2.78%, respectively.

Corporate bond credit seems fine with positive returns year-to-date (YTD) – it just needs a little help from “duration.”

Thinking about the last 15 years, from 2008 to today, the US economy saw 0% interest rates from late 2008 through Q4 ’16, just after President Trump was elected President, and then Janet Yellen (followed by Jay Powell) raised rates up to the 2.5% area by late 2018. Then Covid and the pandemic drove interest rates back to 0% in March ’20 through early ’22.

11 of the last 15 years saw a 0% fed funds rate – it’s probably pretty remarkable that we only have 3.5% – 4% inflation today, given that statistic.

The Treasury yield curve has to eventually return to a positive slope. It always does, but as of today, the catalyst is still unknown: it could be commercial real estate held at both major and regional banks, it could be a string of bad jobs reports (which, as of tonight, seems unlikely), or rapidly decelerating inflation, which also seems unlikely.

Normally this blog doesn’t editorialize, but eventually, something will give.