August 22, 2019

Why the Yield Curve is Back in the Media

Date: August 20, 2019

Author: Courtney Stutts, CFP®

Read time: 2 minutes

 

Over the past few weeks, there’s been a lot of talk about inverted yield curves. If you’re not sure what an “inversion” is or even what the yield curve is, you’re not alone. Google searches for “yield curve inversion” have spiked in the last 12 months as the term has once again hit mainstream media1.

Here’s what you need to know:

 

What is the yield curve?

Put simply, the yield curve is the difference in compensation between short-term and longer-term debt. In a healthy economic environment, the curve should be upward sloping. This makes sense because investors expect to be compensated more while they lend their money for longer periods of time. The longer the commitment, the greater the uncertainty and the higher the demand from investors.

 

What is a flat or inverted yield curve? 

A yield curve goes flat when the spread between short-term and long-term bonds tightens. For example, when the rate for 10-year bonds and 2-year bonds are very similar, the yield curve is flat. This could happen from the Federal Reserve raising short-term rates or from long-term rates declining. If the spread turns negative, meaning short-term rates are yielding more than longer-term rates, the curve is considered “inverted.”

 

Why does this matter?

The yield curve is widely followed because it has historically reflected the market’s gauge of the economy. Going back to the 1970’s, the yield curve has been a reliable indicator of an impending recession, specifically the spread between the 10-year and 2-year Treasury. Since lower interest rates normally mean slower economic growth, an inverted yield curve is frequently seen as a sign that the economy may be slowing soon. It can signal that investors are more pessimistic about the outlook for the economy longer term.

 

Things to consider and other caveats:

1. Just because we see a yield curve inversion doesn’t mean a recession will start tomorrow. The average time from a sustained yield curve inversion to the start of a recession is 14 months, meaning it can take a little over a year for an economic slowdown to hit. Looking back over the last 40 years, it’s even been as long as 24 months.

Inverted Yield Curve

2. Now that the Fed and investors are so aware of the apparent predictive powers of an inversion, does it diminish its power? If there’s an indicator and we’re all aware of it, can it be as effective as it was in the past when nobody was paying attention to it? Since we have the data from past recessions, it’s easier to look for commonalities that we weren’t necessarily looking for in previous markets.

3. During the last 9 inversions, the average 10-year Treasury was yielding 6.1% which is much different than now. At 2% yields, an inversion is a very different situation.

 

Bottom line: The 10-year vs. 2-year inversion can send an important signal but no one knows if it necessarily means the same thing today that it did a decade ago. It’s not a law that an inversion leads to a recession but it’s been a dependable indicator in the past and therefore must be watched. It’s possible that its popularity in the media and the fact that investors are now aware of it could diminish its uselessness going forward.

Sources:

https://trends.google.com/trends/explore?geo=US&q=yield%20curve%20inversion

https://awealthofcommonsense.com/2018/02/yield-curve-inversions-arent-great-for-stocks/

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