The world of economic analysis is awash in indicators. But perhaps none is as renowned as the yield curve. It’s a nifty tool that measures the relationship between interest rates of varying durations. The signals it generates are slow to arrive, but when they do, veteran traders perk up. It’s one of the more potent indicators with a long track record of accurately predicting recessions.
To prep you for today’s commentary I highly recommend reading a newsletter I penned on the topic titled, “People, Meet the Yield Curve.” In it, I deconstruct how the yield curve is created and how it evolves during different stages of the business cycle.
What has the chattering class all aflutter these days is the flattening of the yield curve. Basically, short-term rates (specifically, the yield on two-year treasuries) have risen to their highest levels in a decade. The two-year yield is charted as the blue line in the graphic above. Meanwhile, long-term rates (the yield on ten-year treasuries) haven’t budged. The ten-year yield is the white line in the graphic. That means the spread between the two is as narrow as it’s been in many many years.
The culprit for short-term rates rising is the Fed. As shown in the orange line, the Fed Funds rate is now 1.25% and will soon be lifted to 1.50% during their December meeting. Moreover, Janet Yellen and crew are expected to boost rates multiple times next year, so unless the economy hits the skids, the Fed Funds could soon rise toward 2% to 2.5%. That would bring it in line with 10-year yields (assuming they stay pat at 2.38% or so).
If two-year yields rise above 10-year yields, then we’ll officially have an inverted yield curve. In the past when the yield curve inverts we typically see a recession shortly after that. Although, in the past, it usually took the Fed raising rates north of 5% before the yield curve inverted, so we’ll see if the signal proves as prescient this go around.
The yield curve is just a fancy way to track the impact of the Federal Reserve raising interest rates. Here’s how higher rates can change investor behavior. Let’s say the Fed Funds rises to 2.5%, for example. And, yes, I know 2.5% isn’t that elevated by historical norms, but remember, investors have lived in a zero interest rate environment for almost ten years. The lack of interest received in savings accounts, CDs, and the like has forced income seekers into riskier assets like longer duration Treasuries, high yield bonds, and stocks. This is known as the reach for yield.
If everyone can get 2.5% risk-free, it starts to change investor behavior. All of a sudden the opportunity cost of owning risky assets shifts from nothing to something. Cash becomes attractive again and beckons to capital that would have otherwise flowed into stocks and bonds.
Banks can suffer in this environment as well since they’re effectively paying borrowers short-term rates (which are now high) while receiving long-term rates (which remain stagnant) from outstanding loans.
Even if the Fed maintains its current pace of rate hikes it will still take six to 18 months before the yield curve inverts. And that’s assuming demand for long-term bonds keeps yields depressed on the back end. We’ll keep you apprised of any changes worth mentioning but aside from understanding that a flattening (and eventually inverted) yield curve form towards the latter stages of an economic expansion, I wouldn’t consider this a major warning sign that a recession is imminent just yet.
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