Macro Signposts | 10 July 2024
Unless explicitly stated, views expressed do not constitute official PIMCO views.
Why the U.S. Yield Curve Could Resume Steepening This Year
Policymakers and markets will eventually have to contend with one of the lasting legacies of the pandemic: elevated government debt levels. Government efforts to stabilize their respective economies increased government debt in the G7 developed countries to 140% of GDP in 2020 versus 120% before the pandemic (according to International Monetary Fund data). Inflation has since eroded the real value of the debt back to roughly 130% of GDP, but that's still a level not seen since World War II.
While cyclical developments - including higher central bank policy rates to bring down inflation - have inverted yield curves across the developed economies, in our Secular Outlook essay published back in June 2023, we argued that developed market yield curves would likely steepen over our secular (five-year) horizon as monetary policy returns to neutral (or even fights the next downturn) amid still high government debt levels, and investors demand more return - or "term premium" - to invest in long-dated bonds.
Since that essay published, the 2-year/10-year U.S. Treasury yield curve has shifted from a deep inversion, with the 10-year yield trading roughly 100 basis points (bps) below the 2-year, to a shallower inversion now, with the 10-year yield roughly 30 bps below the 2-year (per Bloomberg data). Much of that steepening happened in the latter half of 2023, as inflation briskly moderated and markets' central bank outlook evolved from how high policy rates would go to when and how much central banks would ease.
Since late 2023, additional progress toward a steeper yield curve has stalled, but looking ahead we wonder if the cyclical and secular stars are aligning for sovereign yield curves, and specifically the U.S. curve, to resume normalizing. The outlook is, as usual, not void of risk, but we see three factors supporting a shift in that direction.
The next monetary easing cycle
First, cyclical economic momentum is building for the Federal Reserve to begin a series of interest rate cuts. Historically, both markets and forecasters have tended to underestimate easing cycles, causing the yield curve to steepen more than implied by the market forwards as the central bank cuts. Our analysis of central bank policy cycles since the 1960s found that across developed economies, even nonrecessionary easing cycles historically averaged around 200 bps to 250 bps of cuts - something markets are not currently pricing.
Furthermore, after stalling, U.S. inflation progress appears poised to resume in the second half of 2024 as rental inflation finally starts to cool. This along with a further easing in labor markets (the ratio of job vacancies to the unemployment rate is now back to pre-pandemic levels after a similar stall in the first quarter) should increase Fed officials' confidence that inflation settles in the "two-point-something" range, if not all the way back to 2%.
Rental inflation has been surprisingly resilient, even accelerating in some of the largest cities. An underappreciated driver of this resilience has likely been the large immigration flows over the last few years. However, with slower immigration in 2024, we believe this factor should fade (see our 25 June 2024 Macro Signposts).
Over time, immigration is likely neutral for inflation, since immigrants raise both demand (by consuming) and supply (by working). However, in the short run, relatively inelastic housing supply, especially in cities that struggle with affordable housing, has meant that immigration has likely driven higher shelter inflation - a key focus for the Fed - even though it may have also contributed to faster wage disinflation in certain sectors, such as leisure and construction.
Immigration affects more than just inflation. It also likely boosted real GDP growth in 2023, which appears poised to moderate as lower inflows of asylum-seeking immigrants, coupled with moderating post-pandemic excess savings and government stimulus, weigh on growth.
Growing fiscal policy uncertainty
A second factor that could support a steeper U.S. yield curve is the evolving outlook for fiscal policy. The U.S. presidential election, as it draws closer, could refocus markets on the challenging longer-term outlook for U.S. government debt, as we've discussed in our secular outlooks. As Libby Cantrill, PIMCO's head of public policy, phrased it in this recent video, the U.S. budget deficit is likely to be the biggest loser of this election - regardless of which party wins.
Markets now also have to consider further potential economic implications of a second Trump term as the challenges facing the Biden campaign increase the odds of another Trump presidency (see our 2 July 2024 Macro Signposts).
If we take former President Trump literally on his stated preferred policy goals (and if Congress is supportive), we may see an aggressive mix of tax cuts and tariffs that could very well be stagflationary and expand the deficit. In a May 2024 paper,1 researchers at the Peterson Institute estimated that levying 60% tariffs on Chinese imports and 10% tariffs on all other trading partners, as Trump has proposed, coupled with a full extension of the Tax Cuts and Jobs Act provisions that expire in 2025, would likely cost the U.S. government an additional $2 trillion to $2.5 trillion over the next 10 years. That would add perhaps 5 to 7 percentage points to the debt-to-GDP ratio that the Congressional Budget Office forecasts could rise to 200% over the next several decades if current policies are maintained.
Furthermore, the magnitude and scope of Trump's tariff strategy would likely hinder U.S. (and global) economic activity while pressuring inflation higher (see our 20 June 2024 Macro Signposts).
Overall, it's a policy mix that could steepen the yield curve as markets contend with higher inflation, a growing deficit, and recession risks.
Lessons from Japan's experience
A third possible impetus for a steeper U.S. yield curve could come - directly and indirectly - from Japan. Market concerns around Japan's debt dynamics appear to be manifesting in a depreciation in the Japanese yen against the U.S. dollar that started to dislocate from 2-year interest rate differentials in early May (at least that's how we interpret the trend). These concerns could evolve into somewhat higher U.S. term premiums if market participants shift focus to the U.S., remembering the many commentators and U.S. policymakers who, over the years, have used the Japanese experience to argue that high U.S. government debt shouldn't pose a problem.
Japanese official institutions' repatriation away from the U.S. bond market could also contribute to near-term supply concerns and higher term premiums. As we discussed in our 14 May 2024 Macro Signposts, the Japanese government has sustained high debt-to-GDP levels over decades because a large pool of domestic household savings allowed it to cheaply fund not only government expenditures, but a large pension fund position in riskier domestic and foreign assets. As higher Japanese inflation has eroded the real value of those household deposits, and the yen has depreciated accordingly, Japanese government portfolios might start repatriating some of the capital from foreign bond markets.
Bottom line
Yield curves inverted as the Fed raised short-term interest rates to fight inflation while term premiums remained relatively low and stable. As inflation has moderated the curve has normalized somewhat, and we believe that normalization should continue in the second half of this year as both inflation and growth momentum could give the Fed the confidence to cut.
Layer on top of that potential policy ramifications of a second Trump term that could cloud the short- and longer-term U.S. fiscal outlook - raising both inflation and recession risks - and we may see the perfect conditions to steepen the U.S. yield curve.
1 Kimberly Clausing and Mary E. Lovely, "Why Trump's tariff proposals would harm working Americans," Peterson Institute for International Economics, Policy Briefs 24-1, May 2024
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