Is the Flattening Yield Curve Actually a Warning Sign?
July 10, 2018
By Krista Biernbaum • Securities Analyst
In a prior commentary, I talked about the return of yield for fixed income investors and how we are currently in a rising interest rate environment. In fact, short-term rates have risen at such a quick pace that we are seeing the yield curve flatten. The direction of the yield curve matters — and here's why.
What is the yield curve?
According to Investopedia, a yield curve is a line that plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates (like a comparison between 2-year and a 10-year Treasury bond, for example).
The most common example involves U.S. Treasuries. The maturities on the curve start at a one-month T-bill and go up to a 30-year Treasury bond. The most common spread investors look at to gauge the direction of the yield curve is the difference between the 2-year and 10-year Treasury notes. The difference between the yield of a 2-year bond and a 10-year bond is called the “spread” — and last week, the spread of the yield curve flattened to its lowest level since before the financial crisis.
The chart below from the Wall Street Journal’s The Daily Shot shows that the spread or slope of the yield curve is now below 30 basis points:
What The Direction of the Yield Curve Means:
Changes in yield curve reflect changes for future economic growth. If the curve is positively sloping (higher yields for longer maturities), it indicates an economic expansion; if it is flattening (short and long interest rates coming closer to equal), it indicates a slower growth environment ahead. When the curve is negative, more commonly referred to as an "inverted yield curve," it suggests troubles ahead for the economy.
Since the yield curve is now at its flattest level in over ten years, investors are starting to worry about it inverting and turning negative, i.e. short-term rates higher than long-term rates. The chart below from the Wall Street Journal’s Daily Shot illustrates that yield curve inversion is “trending” on Google. As the curve has flattened, investors have increased their Google searches for “yield curve inversion” and “inverted yield curve.”
Keeping an Eye on the Curve.
The direction of the yield curve is something we are keeping an eye on because an inverted yield curve is a precursor to a recession. However, do not look at the direction of the curve as a timing device because it can take several months after inverting before a recession occurs. Think of it more as a guide of what is to come, rather than a timing device.
Every market cycle brings stories of why ‘this time it’s different,’ and that the yield curve has lost its predictive value. We disagree. The shape of the curve and the directions of its shifts are an important factor in our decision process. While not indicating the level of expansion witnessed over the last few years, today’s yield curve still suggests reasonable economic growth ahead.
Have you scheduled your mid-year review yet? If not, give your Wealth Management Advisor call today. Also, if you have any questions or want to talk about this article in further detail, don’t hesitate to contact us.