Should You Fear a Flattening Yield Curve?

By: Richard A. Anderson

There has been a lot of talk in the financial media lately about the shape of the U.S. Treasury yield curve. The U.S. Treasury yield curve is a graphical representation of the yields available for short, intermediate and long-term rates of U.S. Treasury securities. The Treasury yield curve is often viewed as a proxy for investor sentiment about the strength of the economy.

Traditionally, the yield curve is upward sloping as short-term bonds have lower yields than long-term bonds. This is illustrated by the normal yield curve below. This is generally the case when investors expect the economy to grow at a normal pace, without significant changes in inflation.

However, the yield curve is not always upward sloping. When short-term rates rise faster than long-term rates, or long-term rates fall faster than short-term rates, this is referred to as a flattening yield curve. In the past, the yield curve has flattened when the Federal Reserve has been raising interest rates.

The spread between the 10-year and 2-year Treasury yields is a way to measure the shape of the yield curve. When the 2-year Treasury yield is higher than the 10-year Treasury yield, this is referred to as an inverted yield curve. For example, a 2-year Treasury Note has a yield of 2.5% and a 10-year Treasury Note has a yield of 2.0%.

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An inverted yield curve is often viewed as a signal that an economic recession and stock bear market is on the horizon. In fact, an inverted yield curve has preceded all five of the past recessions.

Therefore, investors in both bonds and stocks have been concerned that the yield curve might invert. Although evidence supports the notion that an inverted yield curve is a precursor to the start of a recession, it is not an indicator of timing. Over the last five cycles, the start of a recession has ranged from 10 to 24 months following the first month of a negatively sloped yield curve.

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With the 2-year Treasury yield recently hitting its highest level since 2008, the spread between the 10-year and 2-year has narrowed to a level of 0.50%. As of end of day Friday, the 10-Year yield was 2.77% and the 2-Year yield was 2.27%, which is a spread of 0.50%. This is often viewed as a critical indicator because when the spread narrows to this level, it often leads to an inverted yield curve.

Like the timing between an inverted yield curve and the start of a recession, there is a lag between when the yield curve flattens to 0.50% and when it inverts. According to research from LPL Financial, it took nearly a year for the yield curve to invert once it hit 0.50%, though the timing ranged from just under 1 month to 4.5 years.

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Put another way, a flattening or inverted yield curve doesn’t mean a recession is imminent. This is an important indicator and one we monitory closely because it is something that will affect the markets and economy down the road. However, it doesn’t mean there is any action to be taken. As the chart above shows, the markets have historically still had room to run in the time between when the yield curve inverts and when the recession starts. This is because no one single data point can project what will happen in the future. This highlights the importance of not looking at any one statistic or indicator in isolation, rather looking at a number of data points that can help form an opinion on the future of the economy and markets.

The yield curve has flattened in recent years and could invert at some point in the future. While this is a precursor to an economic recession, this is just one data point used to gauge the strength of the economy and markets. At this point in time, the global outlook remains bright as corporate earnings are strong, interest rates are low, inflation is low, and unemployment is low.

If you have any questions about the shape of the yield curve, or the data points used to measure the strength of the economy, please contact a member of the HIGHLAND team.