Yield curve signals danger ahead

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Bond yields have been moving higher since the start of 2018, with expectations of future Fed tightening and a gradual rise in inflation prompting investors to reassess long-term interest rates. This week, the US 10-year Treasury yield hit 3.00% for the first time since January 2014, in signs that the market is on the path to normalisation (see chart below).

US 10-year Treasury yield has risen to a four-year high

 

But while the 10-year yield has moved higher, shorter-term rates have also risen in line with the Fed’s tightening path, producing a very flat looking yield curve. A steepening yield curve typically means investors expect rising inflation and stronger economic growth. In contrast a flat or, more particularly, an inverted yield curve means short-term inflation expectations have accelerated relative to longer-term inflation expectations.

Inverted yield curves have occurred on only eight occasions since 1958. The US economy has slipped into a recession within two years of an inverted yield curve more than two-thirds of the time. As the chart below shows, today’s yield curve is flatter compared to curves associated with previous periods of Fed tightening, indicating that the Fed is tightening into a more precarious economic situation than it has previously.

Today’s yield curve is flatter compared to previous tightening cycles

 

The flattening yield curve has been an area of recent focus, though not consensus, at the Fed. The San Francisco Fed contends that an inverted curve continues to be a predictor of recessions, though former Fed chair Janet Yellen among others believes that given abnormally low cash rates, this time it’s different.

Historically, when the spread between the 2-year and 10-year yield has been very low or negative, an economic slowdown has followed. As the chart below shows, a negative spread has proved a reliable indicator of a future downturn in equity markets.
Very low or negative spreads can signal a fall in equities

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