Institutional investors and economists have been closely eyeing the flattening yield curve in credit markets and what that could portend for the economy.
As a confluence of factors like inflation and tightening monetary policy impact the global economy, a flattening curve could spell trouble for capital markets and the corporations that rely on them. The implications for the U.S. and global economy could also lead to a wider spread economic slowdown.
Nick Tell is the CEO of Armory Group, a leading investment banking and advisory firm for middle market companies. As the potential for a flattening yield curve looms over financial markets, Nick has outlined what this could mean for investors as well as middle market companies, which are among America’s biggest creators of jobs.
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What is the Flattening Yield Curve?
A flat yield curve occurs when there is minimal difference between the short-term and long-term return rates on bonds with the same credit quality. For instance, let’s say that the U.S Treasury is offering two-year bonds with a 3% yield. If the yield for 30-year bonds is only approximately 3.2%, then this would be considered to be a flat yield curve.
While the yield curve is not yet “flat,” it is flattening. This process means that the gap between long-term and short-term return rates is shrinking. The flattening effect occurs when short-term interest rates increase more rapidly than long-term yields. Rapidly falling long-term rates may also cause the curve to flatten.
What Factors are Causing the Flattening Yield Curve?
Tell attributs the flat yield curve to inflation. Specifically, he has said that inflation is impacting the yield curve in the following three ways:
Broadening of Inflation in the U.S.
“The Fed expected that [consumer spending on goods] would abate in favor of increased spending on services,” said Tell. Unfortunately, this has not occurred. In fact, consumer spending on goods remains strong.
In addition, the U.S. is beginning to experience broadening inflation. At the outset of the pandemic, inflation only impacted a “narrow group of goods and services.” However, these price increases are now affecting staples such as poultry, beef, hospital services, and even electricity.
The broadening inflation is being compounded by widespread resignations and a general lack of participation in the labor force. This lack has forced many businesses to increase wages, which in turn fuels inflation.
Global Inflation Pressures
Internal inflation is not the only factor driving the flattening yield curve. Historically, various global forces have prevented the U.S. from experiencing unusually high rates of inflation.
Tell believes that there are signs that “these forces may be becoming less powerful.” His belief is supported by the fact that import prices have sharply increased, even though the U.S. Dollar remains strong.
Rising import prices may create a trickle-down effect. The U.S. Dollar could weaken, thereby accelerating import price inflation.
Price increases have been so significant that they are now a prominent topic discussed by everyday consumers. When talking about the link between politics and inflation, Tell referenced an October 2021 survey. The survey demonstrated that the majority (62%) of Americans blame current inflation rates on President Biden’s policies.
Public sentiments are prompting democratic politicians across the nation to take action. They are pressuring the current administration to slow inflation rates before the rapidly approaching mid-term elections in November of 2022.
What the Flattening Yield Curve Means for the Economy
Generally, a flattening yield curve serves as a precursor to a long-term economic slowdown. However, Tell clarified that the economy will not feel the impact of the change until “the Fed actually starts raising rates.”
Still, inflation rates and the flattening yield curve can have significant impacts on U.S. businesses in several ways, including the following:
Falling Corporate Valuations
The flattening yield curve will likely cause corporate valuations to fall across the board. Tell predicts that PE ratios “will compress as the call option portion goes to zero” when Fed rates increase. He also expects the overall market to remain highly volatile, which will cause risky assets to become less valuable.
If short-term rates increase, it will negatively impact a company’s ability to access credit. Tell noted that roughly 80% of the debt of “small to middle-market companies is floating rate.” This debt typically consists of LIBOR-calculated rates. LIBOR is especially sensitive to Fed interest rates, according to Sell.
While the sensitivity of LIBOR is of major concern, there are more pressing issues that will likely magnify the credit crunch for small businesses. The combination of supply chain disruptions, wage inflation, food inflation, and increased severity of storms along the gulf coast will lead to what is known as “stagflation.”
Stagflation occurs when a nation experiences slowed economic growth and high inflation simultaneously.
Businesses must keep a close watch on the yield curve in the coming months. By doing so, they can remain agile and more effectively weather the high inflation that is likely to continue well into 2022.
In addition, organizations of all sizes must take steps to prepare now. They must develop asset management strategies that are designed to offset potentially reduced profit margins as interest rates rise.