Is the yield curve about to flip?

If the yield curve reverses and investors are willing to accept lower rates on long-term debt than short-term, it bodes ill for the economy, says John Stepek.

906_Strategy

In December I highlighted an unusual and worrying phenomenon in the bond market the threat of an "inverted yield curve". This relatively rare event has a remarkably good track record of predicting recessions. In the seven months since I wrote that piece, the yield curve has only flattened still further, growing ever closer to the dreaded inversion point.

A quick recap: the yield curve refers to the shape you get if you plot the yields on bonds (IOUs issued by companies and governments) of ever-increasing maturities on a graph. Usually, short-term bonds pay a lower yield than longer-term bonds. So a two-year US government bond will pay less than a ten-year one. That's because investors will usually demand a better return for locking their money up over a longer period of time, because there's a higher risk of inflation or default denting their wealth.

When the yield curve flattens, it means the gap (or "spread" see below) between short-term debt and long-term is narrowing. As the chart shows, the yield curve is far flatter today than it was five years ago, for example. And it's only getting flatter. In December the spread between the two and the ten-year US Treasury was above 0.5% now it's below 0.35%. And if it inverts, it shows that long-term debt is actually yielding less than short-term debt. Typically, that's because investors are worried that a recession is around the corner, which will stifle inflation, and force central banks to reduce interest rates.

Former Federal Reserve chairman Ben Bernanke said this week that we should be wary of reading too much into the flattening yield curve. That may be a fair point with quantitative easing elsewhere in the world (Japan and Europe), plenty of money is still flowing into longer-term Treasuries, which may be suppressing rates. But Bernanke has form here. He dismissed the significance of the inverting yield curve in 2006, when he became Fed chair. As the ensuing crisis demonstrated, he was wrong to do so. It would be foolhardy to make the same mistake again.

Of course, the yield curve hasn't turned down yet. In fact, on Friday last week, as John Authers notes in the Financial Times, the curve actually steepened at its fastest rate (in percentage terms) since the financial crisis. Now, given its current flatness, that doesn't mean a lot in absolute terms. But it does suggest that inversion may still be avoided for now. And that would make sense as Authers notes, the curve has "looked out of place with other measures suggesting that the prime danger is overheating". That said, while an escape from our "deflationary torpor" is to be welcomed, higher rates would bring their own problems. But that's a discussion for another day.

Recommended

Bonds
Glossary

Bonds

A bond is a type of IOU issued by a government, local authority or company to raise money.
19 May 2020
The giant investment platforms and the risk to shareholder capitalism
Investment strategy

The giant investment platforms and the risk to shareholder capitalism

The fact that so many of us invest via the big investment platforms means that there is a huge dislocation between the owner of the shares (us) and th…
23 Apr 2021
Vanguard's financial advice revolution
Investment strategy

Vanguard's financial advice revolution

Vanguard’s financial-planning product is transparent, cheap and low-hassle. The competition had better watch out
23 Apr 2021
Why investment advice could be about to get a lot cheaper
Investment strategy

Why investment advice could be about to get a lot cheaper

Vanguard, the world’s second-biggest asset manager, is launching its own cut-price financial advice service. It’s something the industry badly needs, …
20 Apr 2021

Most Popular

China owns a lot more gold than it’s letting on – and here’s why
Gold

China owns a lot more gold than it’s letting on – and here’s why

In a world awash with money-printing, a currency backed by gold would have great credibility. And China – with designs on the yuan becoming the world’…
21 Apr 2021
“Joke” cryptocurrency dogecoin goes to the moon. What’s going on?
Bitcoin

“Joke” cryptocurrency dogecoin goes to the moon. What’s going on?

Dogecoin – a cryptocurrency created as a joke – has risen by more than 9,000% this year alone. Saloni Sardana looks at how something that began as an …
19 Apr 2021
House prices in the UK are still surging – here’s why it’ll probably continue
Property

House prices in the UK are still surging – here’s why it’ll probably continue

The latest UK house price data shows no letup in the country’s booming property market, with the biggest yearly rise since 2014. And there’s no end in…
22 Apr 2021