What the yield curve says about markets

Markets have many things to fret about right now – nagging concerns about geopolitics, the striking examples of over-exuberance cropping up everywhere, and the concomitant fear of missing out on even more gains by being too bearish. But now something rather more esoteric is drawing the attention of more cautious investors. That something is the flattening yield curve. 

What does that mean? The yield curve compares the yield on bonds that have the same credit quality, but different maturities (so for example, the US Treasury yield curve would chart the yields on everything fom three-month US government debt to a 30-year Treasury bond). The yield curve normally slopes upwards from bottom left to top right. In other words, longer-dated bonds yield more than shorter-term ones, because today’s money is worth more than money in a year’s time. For taking the risk of waiting for longer to be repaid, you demand more interest.

If the yield curve starts to flatten – in other words, the “spread” between yields on short-term bonds and long-term ones narrows – then it may be a sign that investors believe inflation is set to fall (and so they don’t demand as high an interest rate from longer-term bonds) or that short-term interest rates are set to rise (driving up the yield on shorter-term bonds), or both. This is cause for concern because a flat yield curve can give way to an inverted one.

When that happens, it shows that investors expect interest rates in the future to be lower than they are today. As a result, they are happy to lock in today’s yields on longer-term bonds, because they expect them to be even lower tomorrow. That in turn indicates that they are anticipating an economic slowdown or even recession, which might result in low inflation or deflation, and the central bank having to cut rates.

An inverted yield curve has appeared prior to every single one of the last seven US recessions. What’s worrying is that, right now, the US yield curve is flattening fast and is now the flattest it’s been since 2007, which was of course just ahead of the global financial crisis.

So what’s the yield curve telling us today? As The Economist points out, it could be due to overseas investors piling into relatively high-yielding US Treasuries (and so suppressing long-term rates even as short-term ones rise), or it may represent scepticism that inflation in the US is really about to take off, as the Federal Reserve fears it will. Yet the simplest and most likely explanation is that “markets are losing confidence in the Fed’s ability to raise rates without inflation sagging”.

As Jonathan Allum of broker SMBC Nikko notes, this gives rise to another risk – if the Fed is right and inflation does take off, we could see a “crash in bond markets” as Treasury investors reverse their bets fast.