An economic concept known as the “yield curve” has been getting a lot of attention recently among economists and on Wall Street. In fact, some pundits are saying that the yield curve is dangerously close to predicting a recession here in the U.S.
So what exactly is the yield curve? And more important, is the yield curve pointing in the direction of a recession for the U.S. economy?
The Yield Curve Explained
The U.S. government issues debt instruments with varying maturities. These include short-term Treasury notes with a maturity of two years and long-term Treasury notes with a maturity of 10 years. The difference between interest rates paid on short- and long-term Treasuries is referred to as the yield curve.
In a healthy economy, longer-term government bonds pay a higher interest rate than shorter-term government bonds. This is to compensate investors for the risk that inflation could reduce the value of longer-term debt.
When the spread between rates paid on short- and long-term Treasuries starts to narrow, this is referred to as a “flattening” of the yield curve. If long-term rates actually fall below short-term rates, this is referred to as an “inverted” yield curve. And this, many market watchers say, could be an indication that a recession is on the way.
According to researchers at the Federal Reserve Bank of San Francisco, all nine recessions that have occurred over the past 60 years were preceded by an inverted yield curve. What’s more, there was only one instance in the mid-1960s in which an inverted yield curve wasn’t followed by a recession.
Scant Signs of Recession
Right now, there appear to be scant signs of a recession on the horizon. Economic growth and employment are both strong, corporate investment is gaining steam and consumer spending is rebounding.
However, the yield curve has been flattening every since the Federal Reserve started raising interest rates nearly three years ago. The yield curve recently stood at less than 0.3 percentage points, the lowest level it’s been since 2007. With the Fed recently signaling that it intends to continue raising short-term interest rates gradually into 2019, it seems like just a matter of time before the yield curve becomes inverted.
So if and when this happens, does it mean that a recession is inevitable? Not necessarily, say some economists. They point to the fact that the flattening of the yield curve is primarily due to the influence of central bank moves on short- and long-term rates, rather than the free market.
If the Fed’s bond-buying program is pushing rates on long-term Treasuries lower while its monetary tightening is pushing short-term rates higher, the yield curve is going to naturally flatten. This is making the long-term yield curve a less-reliable indicator of recession than it used to be, these economists believe.
A Near-Term Yield Curve
There’s a growing belief that a different kind of yield curve is a better predictor of recession in the current economic environment, such as one that measures the difference in current interest rates on three-month Treasury bills and their expected rates in 18 months.
Some economists believe that this kind of “near-term” yield curve provides a more timely recession signal that’s less influenced by larger non-economic forces. For example, economists at the Federal Open Market Committee (FOMC) meeting in June said they believe this yield curve is a better predictor of recession in the coming year, and that it shows minimal recession risk in the near term.
Please contact us if you have more questions about the yield curve and how it could affect your financial and investing strategies.