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Investment Strategy

Welcome to the Funhouse

By Elliott H. Gue, on Jun. 24, 2016

Danger: Flattening Yield Curve

Over the decades, the slope of the US yield curve has demonstrated its value in predicting impending recessions. In particular, an inverted yield curve—a phenomenon that occurs when Treasury securities offer higher yields than long-term bonds—historically has signaled a heightened risk of recession.

The yield curve has flattened considerably over the past year because of the uptick in short-term interest rates and a significant decline in the yield on long-term government bonds. In fact, the yield spread between 10- and two-year US Treasury bonds narrowed to 89.1 basis points on June 14, 2016—the lowest reading since late 2007.

(Click graph to enlarge.)Yield Curve

Expectations for modest inflation and weak US economic growth over the next few years have driven the decline in yields on 10- and 30-year government bonds, a trend that limits the Federal Reserve’s ability to tighten monetary policy.

On the other side of the equation, the increase in short-term interest rates stems primarily from the Fed hiking the benchmark rate by 25 basis points at the end of 2015.

When the Federal Reserve keeps short-term interest rates low in a healthy economic environment, the yield curve steepens because the market prices in expectations of stronger GDP growth and the need for higher rates down the line.

Trends in the US yield curve over the past year suggest a lack of confidence in the US economy and the Fed’s ability to normalize monetary policy.

Some bullish commentators dismiss concerns about the flattening yield curve by pointing out that this metric hasn’t inverted—that is, short-term interest rates remain lower than the coupon rate on longer-term Treasury bonds.

However, with short-term interest rates still less than 0.5 percent in the US, an inverted yield curve is practically impossible. Analysts have developed several mathematical models that adjust the yield curve to account for the Fed’s near-zero interest rate policy; these models usually indicate that the US yield curve has been inverted for most of 2016.

Fed Lowers Forecast

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