The U.S. yield curve’s recent steepening–after a period of persistent flattening–reminds us that the spread between two- and 10-year Treasury yields reflects much more than the state of the U.S. economy. Global interest rates and monetary policy also play a role in shaping the curve, with a recent tweak in Bank of Japan (BoJ) policy helping drive the mild steepening.

The BoJ announced it would allow 10-year bonds to move in a wider range. Why would this affect the U.S. yield curve? Global investors often seek out the highest long-term yields. The U.S. was the most attractive destination among developed markets for some time, given its greater progress toward economic recovery and rate normalization. This spurred inflows to U.S. debt markets that helped contain the rise in long-term Treasury yields, as Fed rate increases pushed up the short end. The result: a closing gap between 10- and two-year yields, as the orange line in the chart above shows. The German curve, by contrast, remained relatively steep (green line). Now, as evident in the far right of the chart, we are seeing the U.S. yield curve steepen a bit amid speculation that rising yields in Japan could lure Japanese investors back home and prompt them to sell some of their holdings in long-term U.S. debt.

Strong growth, but rising uncertainty.

Rising long-term Treasury yields should help alleviate market concern of a U.S. yield curve inversion–a signal that often prompts fears of a recession. The curve’s persistent flattening has been led by increases in short-term interest rates amid rising market confidence that the Fed will carry on with policy normalization. Markets are now pricing a high probability of the Fed raising rates another quarter percentage point at its September meeting, and we see one additional 2018 increase likely to follow. This confidence has been fueled by strong U.S. economic momentum. Our BlackRock Growth GPS signals U.S. growth well above trend over the coming year and indicates consensus expectations of U.S. growth prospects may still be too cautious. Insatiable global appetite for both yield and perceived “safe” assets, along with high global savings, will continue to help hold down the long end of the U.S. curve, in our view.

We see strong U.S. growth spilling over into the global economy. Our GPS points to steady and sustained global growth over the coming 12 months–even as economic uncertainties rise due to U.S. overheating risks and escalation of trade conflicts. Major central banks outside the U.S. are preparing to move toward normalization, albeit much more slowly than the Fed. We see global investors seeking out higher currency-hedged yields in these regions, potentially reducing their demand for U.S. Treasuries. Supply factors are driving up longer-term U.S. rates, too. A recent U.S. Treasury Department advisory report suggested shifting more issuance toward longer maturities as the Treasury seeks to fund the U.S. fiscal deficit.

The bottom line.

The U.S. yield curve provides less information about recession risk than it has historically and is shaped by many factors. We see solid growth ahead, but rising macro uncertainty underscores the role of fixed income as ballast in portfolios. We prefer short-duration debt in this rising rate environment and favor an up-in-quality stance in credit as an offset to equity exposure.

Richard Turnill is BlackRock’s global chief investment strategist. He is a regular contributor to The Blog.

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