The Flattening Yield Curve Means Trouble Ahead. Here’s What You Need To Know.

April 17, 2018

The Flattening Yield Curve Means Trouble Ahead. Here’s What You Need To Know.

  • What is the yield curve?
  • The yield curve is flattening and if it inverts, there will be a recession.
  • What you can do.



Introduction

In this article, I’m going to explain what the yield curve is, what a flattening or steepening yield curve means, how the yield curve impacts the economy, and see whether the current yield curve indicates that we are close to a recession in 2018.

What Is The Yield Curve?

The yield curve is a chart showing the yield on bonds starting with short term maturities to long term maturities. The bond maturities are from one month to 30 years.

Figure 1: Current U.S. yield curve. Source: Bloomberg.

The green line above shows how yields on short term maturities were low in 2015 at 0.25%, and much higher for long term maturities between 2 and 3%. The black curve shows how the yield curve has flattened over the last 3 years and even a bit since February 2018 as the current yield curve (blue) is bit flatter.

The one month Treasury yield is 1.65% while the 30-year Treasury yield is 3.05%. So, over the last 2 years, the short term yield has increased from 0.25% to 1.65% while the long term yield stayed at 3%. This means that the yield curve is flattening and this has extreme repercussions on the economy.

What the yield curve is showing is the cost of borrowing money over time for the U.S. government in this case.



Steepening & Flattening Yield Curve

The yield curve can be flat or steep. This can best be seen by comparing the U.S. yield curve in 2007 and 2010.

Figure 2: Yield curve in 2007 and 2010. Source: Fidelity.

A steep yield curve is usually at the beginning of an economic expansion. Investors fear future higher inflation and demand a higher return for the long term, but the central bank still keeps short term rates low. Thus, the yield steepens.

A flat yield curve shows that long term investors are willing to take a yield equal to what short term investors will take in order to lock in the yield for the longer term. This means they are expecting lower yields in the future. And, historically, it has been the case that economic recessions follow a flat yield curve.

If we deduct the 2-year Treasury yield from the 10-year Treasury yield and check for recessions in the past, we can see that a flat curve (no difference between the two) isn’t usually a good sign.

Figure 3: 10-year Treasury yield minus 2-Year Treasury yield. Source: FRED.

After a short period with a flattish curve, we saw a recession in 2008. The period was a bit longer in the 1990s, another short period prior to the 1991 recession, and an inverted curve before the 1979, and 1982 recessions. The chart above shows how the yield curve isn’t perfect at predicting a recession, but it sure is good. Recent research from the Federal Reserve Bank of San Francisco (FRBSF) found, and I quote:

“A negative term spread, that is, an inverted yield curve, reliably predicts low future output growth and indicates a high probability of recession.”

Therefore, as investors, we need to take into consideration that there is a high probability for a U.S. recession in the coming years.



The Yield Curve In 2018 & Upcoming Recession

The current term spread between the 10-year Treasury and the 2-year Treasury is 0.49% and given that the FED plans to raise rates constantly over then next two years and hopes to hit 3% by 2020, that flattening yield curve could turn negative and we would face an economic slowdown.

Over the last 70 years, as soon as the yield curve has turned negative, there has been a recession in the next two years with a recession starting within 6 and 24 months from the term spread turning negative.

Figure 4: Term spread and NBER recessions. Source: FRBSF.

The decline in the term spread was driven by a sharp increase in interest rates where long term rates stay stable, or even decline like we’re experiencing now.

The Economics Of A Flattening Yield Curve

So, what happens when the yield flattens and why?

Well, long term interest rates reflect the expectations of future economic conditions and we all know an economy can’t grow forever because it is cyclical in nature. When investors become increasingly pessimistic over economic activity, long term rates don’t grow anymore because they expect lower longer term yields and thus the yield flattens. A flatter yield curve also makes it less attractive for banks to lend long term which dampens loan supply and tightens credit conditions. In a credit world, tightening credit leads to an obvious recession.

The Probability Of A Recession

FRBSF data shows that the probability of a recession coming soon is high and also accurate.

Figure 5: Probability of recession. Source: FRBSF.



We aren’t there yet, but if the FED keeps raising rates, we will be there soon and by soon I mean within a few years. However, many say “this time is different” because interest rates are still historically low and might not negatively impact the economy or just slow down the economy less than usual.

Conclusion

Given all of the above, it’s unlikely that the FED will be able to continue on its tightening path without creating an inverted yield and thus leading the economy into a recession over the next few years. The yield term is staring you in the face and telling you the risks are rising day by day while you still have the opportunity to rebalance at extremely high market levels. Who says markets aren’t nice or fair?

For investors, this is extremely important in relation to asset allocation and portfolio weights. After enjoying 8 years of strong growth cumulating in 2017 with huge emerging market growth, it might be time to reduce your risks and prepare for a normal and natural economic downturn.

So, what should you do about all of this?

Well, a recession means bad times but bad times mean also opportunity. Tomorrow we will discuss the psychological influence of bear markets and then over the coming months, we are going to analyze sectors and stocks to see which ones will be the best going into a recession and which will be the best after a recession. Keep reading.



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