Are Retail Reports a Sign of a Slowing Recovery?

Will Increasing Oil Prices Put a Ceiling on Global Economic Growth?

How Will Uncertain Inflation Outlook Impact Stock Market?

Will The Federal Reserve Create a Taper Tantrum in 2021?

How Will a Steepening Yield Curve Impact Markets?

Based on data from the Federal Reserve Bank of St. Louis, the spread between the 10-year and two-year constant maturity Treasury rates increased by 66 basis points – from 0.48 percent in July 2020 to 1.14 percent by February 2021. Due to the Federal Reserve’s open market operations, two-year notes have fallen to near 0 percent, while the 10-year yield has risen higher.

Experienced investors and financial institutions such as the Federal Reserve Bank of St. Louis would see this change in the slope of the yield curve of the two U.S. Treasury rates and call it a steepening yield curve. This recent widening spread illustrates what a steepening yield curve looks like and how it impacts the economy moving forward.

The Federal Reserve Bank of St. Louis attributes the steepening yield curve to fiscal stimulus and the mass adoption of COVID-19 vaccinations. These two factors could be indicative of future economic growth, including stock market earnings and job gains.

The Yield Curve as Predictor

When it comes to the yield curve and employment, the Federal Reserve Bank of St. Louis explains how the two are related.

Employment growth mirrors the spread in the 10-year and two-year Treasury notes. When the yield curve first steepens, employment numbers might be negative. However, because the steepening yield curve projects increased economic growth, employment growth will soon follow a similar positive growth trajectory.

Historically speaking, the association between the yield curve’s increasing spread and future economic growth keeps its positive trajectory movement over time. This association, based on historical data from the Federal Reserve Bank of St. Louis, has been able to project between 18 months and 36 months of positive future economic growth and approximately 30 months of a positive yield spread and employment growth trend.

While the Federal Reserve Bank of St. Louis is uncertain about much inflation will accompany the economic expansion, it is confident that the Federal Open Market Committee (FOMC) will  keep short-term interest rates low to contain borrowing costs and help boost strong financial markets through projected positive economic growth going forward.

Widening Yield Curve and Bank Earnings

As the Federal Deposit Insurance Corporation (FDIC) explains, banks benefit from a steep yield curve because they engage in maturity transformation. The New York University’s Leonard N. Stern School of Business defines maturity transformation as when banks borrow short-term and lend long-term. This lets banks profit from the mean of the short- and long-term rates, the so-called term premium. Term premium is how much premium long-term government bond holders realistically anticipate they will receive versus a string of short-term bonds that might have differing interest rates. Buyers of long-term bonds receive payment in exchange for the uncertainty of changing short-term interest rates.

A widening yield curve also can impact a bank’s net interest margin. According to the Federal Reserve Bank of San Francisco, net interest margin is what’s left over for the bank after deducting interest expenses from interest income. Donald Kohn explains that if short-term interest rates increase, interest costs accordingly increase to interest income. This would lower net interest margins as well as the bank’s holdings.

Assuming there are no further negative economic headwinds, history tells us there is a reasonable expectation of an economic resurgence from the coronavirus pandemic.

Coronavirus: Black Swan or Buying Opportunity?

According to the World Economic Forum (WEF), the spread of the coronavirus will impact the world’s economy. Whether it’s a Reuter’s poll from economic experts projecting growth in China slowing to 4.5 percent in Q1 of 2020, in contrast to China’s Q4 GDP of 6 percent; or the International Energy Agency (IEA) saying world desire for oil will be lower due to the coronavirus; or global companies reducing or temporarily closing their Chinese factories, change is on its way. Based on this data, what does the global economic outlook entail?

In order to understand how the coronavirus might impact global economies, it’s important to put this in context of other global events. Based on a February 2020 Monetary Policy Report from The Federal Reserve, there’s a mixed outlook for recent and projected economic activity. While the Fed notes that oil prices have increased over the past six months of 2019, in part due to OPEC members cutting production and brief tensions with Iran in January 2020, The Fed attributes more recent drops in oil prices to the coronavirus and associated lowered global demand.

Due to China’s already slowing economy, the IEA is projecting 435,000 fewer barrels of oil on an annual basis during Q1 of 2020, the worst in a decade. Looking at statistics from the United Nation’s International Civil Aviation Organization (ICAO), airlines are expected to see revenue losses of between $4 billion and $5 billion in the first three months of 2020. With the coronavirus impacting China, thereby reducing outbound travel to Japan and Thailand, losses could be as big as $1.29 billion and $1.15 billion for each respective country.

The Fed explains that in 2019, manufacturing has been challenged both globally and domestically. Citing the industrial production (IP) index, the first six months of 2019 saw declines in both domestic and global activity. For 2019, U.S. production dropped by 1.3 percent for durable and non-durable goods. This is attributed to trade issues with China, soft economic growth worldwide, less than aggressive investment from businesses, declining oil prices that lower continued production by crude producers and production issues with Boeing’s 737 Max airplanes.

However, despite the manufacturing slowdown in China, the United States’ manufacturing base shouldn’t see the same impact from the coronavirus. The Fed says that factoring in purchasing materials for production on the input end, and transporting, wholesaling and retailing products post production, the drop of 1.3 percent on the industrial production index equates to a 0.5 percent drop in U.S. GDP. For context, compared to the U.S. manufacturing employing 30 percent of workers 70 years ago, it presently employs 9 percent of workers.

One way to see how the coronavirus might play out is to look at how SARS impacted China in 2003. Based on data from the National Bureau of Statistics in China, it took three months, during Q1 of 2003, where China’s economic growth dropped to 9.1 percent, from 11.1 percent. While a much smaller economy, on a global scale, in future quarters China was able to grow at an annualized rate of 10 percent, per Refinitiv. However, economists note that if SARS didn’t impact China, there could have been another 0.5 percent to 1 percent increase in annual growth.

Another comparison with SARS is China’s retail sales. Refinitiv shows that May 2003 retail sales dropped to 4.3 percent. This is compared to between 8 percent and 10 percent for retail sales figures in March 2003 and July 2003, showing how serious the impact SARS made, but also China’s resiliency.

While the Chinese economy impacts the global economy today more than when SARS hit, it also has a more responsive economy and a larger middle class. Only time will tell as to the coronavirus’ impact, but based on past experience, it should only be a matter of time before China’s (and the global) economy bounces back to greater economic output.