Yield Curve inversion - should we worry?

If you follow financial news, there is a good chance that you might have noticed the mention of flattening of the yield curve over the past couple of months.

What is a yield curve?

The yield curve is a curve showing yields or interest rates across different bond contract maturities. In a normal environment, the yield is higher for longer maturity bond and lower for shorter maturity bonds.

Here the concept is very simple. If you leave money in a fixed deposit account for 5 years you expect a higher rate than if you leave it for 1 year. The reason is because you are taking more risk and thus you deserve a higher reward.

When long term interest rates are getting closer to short term interest rates, the yield curve starts to flatten and a flatter yield curve starts to develop.

The flat yield curve can develop further and turn to ‘inverted’ and this happens when long term rates fall below short-term rates.


 

Why is the yield curve important?

The most important yield curve to follow is for that the US Treasuries. More specifically, we need to look at the difference between the 10 year and the 2-year bonds which has been a historical indicator of the health of the economy and markets.

The spread between the 2 year and 10 year has been slowly decreasing over time since the financial crises (see chart below). In 2014 for instance, the spread was 1.94% whilst today the curve is getting flatter as the difference is just 0.56%!.

Despite several hikes of the Federal Funds rate this year, long-term rates have not kept pace, causing the yield curve to flatten and stoking fears of a recession. When spreads between short- and long-term rates narrow, it suggests that the market believes economic growth and inflation are not sustainable and will fall in the future.

The major concern here is that when yield curve dips into inverted territory, there seems to be extremely high correlation with market contractions and/or slow economic growth.

Although this has been a very reliable indicator in the past, we need to keep in mind some important points:

1) Yield curve flattening is something to watch careful however it is fully inversion what matters most. As the below chart shows the yield curve inverts about 12-18 months prior to a recession however, right now the yield curve is just getting flatter, not inverted.

2) A flatter yield curve today is not a strange phenomenon considering the actions coming from the US Federal Reserve. Going back to the chart below, yield curves typically flatten over the course of a rate hiking cycle therefore, the movements we are seeing today are not at odds with history.

3. Since the financial crisis, central banks around the world have cut rates to record lows and purchased approximately $11 trillion in global government bonds. Large amounts of monetary policy stimulus has no doubt stretched the fixed income markets meaning that they may no longer be the same tool as they use to be.

To conclude I don’t think that the yield curve is currently forecasting recession. However, we might be in the caution zone. Continued Federal Reserve tightening, along with soft credit demand, could indicate that recession is looming. It is in this manner that we need to find investments that are suitable in different periods so we can weather any storm that can lie ahead, without losing out the momentum from this long-term bull trend.

 

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