Stocks, real estate and other risk assets have experienced double-digit rallies since the election of Donald Trump. These market have shrugged off cyclical pressure and the end of quantitative easing in a way that Wall Street analysts never expected.
Most economic indicators are flashing positive signals for 2018. Goldman Sachs raised its growth outlook for 2018 to 2.5% and revised its forecast for unemployment to 3.7% by the end of 2018, a number which most would interpret as “full employment”.
The yield curve has been left in the dust by the rally in risk assets. The US 2’s10’s yield curve has flattened to 56.6 basis points. The last four times that the 2’s10’s traded this flat, the economy was already in a recession.
For banks, whose principal business is to barrow-short and lend-long a flat yield curve tightens profit margins and increases balance sheet risk. As the yield curve flattens and margins shrink for financial institutions, leverage naturally increases.
In China, where financial conditions have tightened significantly, the sovereign yield curve has already become inverted.
A flattening yield curve is not a sure sign that the market and economy are headed towards disaster, but it’s not an indicator that investors can afford to completely ignore.