Despite stronger economic growth in Q2 2018, further Fed tightening and a bearish consensus that US interest rates would go substantially higher in 2018/19, financial markets now signal concern about weaker economic growth and inflation. This is shown in (1) the flattening of the US yield curve (10 yr – 2yr yields; see Chart 1), (2) stable inflation breakevens or expectations, (3) a modest de-rating of the US equity market, and (4) flat to weaker equity market performance globally in 2018 v 2017. Forecasts of a decisive break above 3% in 10 year Treasury yields have also been confounded and once again, the financial market consensus on higher growth, inflation and “ normalisation “ of interest rates has been mistaken. It is still too early to declare a final outcome, but the failure of those economies further advanced in the economic cycle – notably the US – to show more than modest late-cycle capacity strains and inflation pressures may have dealt the final blow to those expecting interest rates to “ normalise” at pre-GFC levels.
Since an inverted US yield curve has been a reliable leading indicator of US recessions in 8 of the last 9 business cycles, financial markets are also paying heed to the curve flattening of recent months. This has left the US yield curve at its flattest since 2007 (Chart 1)- with a positive gradient of 23bp – when it inverted 12 months before the deep recession of 2008/09.