The yield curve is perhaps the most widely used benchmark when discussing U.S. government debt obligations as well as other fixed income securities. What exactly is it and why does it matter? For bonds having equal credit quality but differing maturity dates, the yield curve is a line that plots the interest rates at a set point in time. The reason for this is so that we may analyze the difference, or spread, between shorter interest rates and longer term interest rates to see how much premium investors are receiving for investing in longer term bonds, which is a normal expectation. For example, the most popular yield curve that gets reported is the one describing U.S. Treasury debt because it tends to be the benchmark for other debt in the market such as bank lending rates or mortgage rates. You might be asking yourself, “Great, so now why does this matter?” Well, it matters because besides helping form the basis for other forms of debt in the fixed income space, it also tends to be what economists call a leading indicator for the economy. Leading indicators tend to (not always) change before the rest of the economy changes direction. A “normal” yield curve, like the one from a year ago, shows a positive slope and this means that investors are being rewarded more for leaving their money in longer. On 8/3/2017, the 3 Yr treasury yield sat at 1.49% and the 30 Yr yield sat at 2.81% or a spread of 1.32% . As of yesterday, (8/2/2018) the 3 Yr Treasury yield was at 2.76% and the 30 Yr yield was at 3.12% for a spread of 36 bps (0.36%). This means the yield curve is flattening out because investors are being rewarded less for longer term maturities. A large influence on this is investor expectations and the general direction of future rates. During robust market conditions a normal, positive sloping curve doesn’t necessarily prompt investors to jump into longer term bonds because of the negatively correlated relationship between prices and yields. This is because if market participants expected future yields to rise in the future, bond prices would fall… and the longer the term of the maturity, the more its price would decline. If we look at what preceded the previous recession in 2008, the Fed was aggressively raising short-term interest rates to combat inflation from the booming housing market and thus pushed short-term rates above 5%. Long-term rates also rose but were just below 5% and the yield curve inverted just before the bubble popped and the stock market collapsed. Inverted yield curves have always followed restrictive market conditions that were undertaken to control inflation and prevent the economy from overheating. Burton Malkiel who wrote the cornerstone finance book called “A Random Walk Down Wall Street” had an excellent piece in the Wall Street Journal this week where he talks about the previous recessionary environment compared to today:
“How does the situation compare today? Both short-term and 10-year interest rates are below 3%. With inflation running at 2%, real interest rates are low (under 1%), and the yield curve has yet to invert. There appear to be few speculative excesses in the economy. Moreover, even if the Fed pushed short-term rates another percentage point higher, monetary policy would remain broadly accommodating. Restrictive monetary policy has often led to declines in economic activity. But today the Fed is trying only to normalize rates, not take the punch bowl away. Real interest rates remain at historically low levels.”
He then goes on to explain how it’s dangerous to think “this time is different.” He also says however, the current global financial markets make interpretation of the yield curve more difficult. U.S. Treasury rates look much more attractive than their Euro Zone and Japanese counterparts because their rates are still extremely low or have even been negative. Lower long term rates in this environment may emit a different signal than what has happened in the past. To wrap up, because of the accommodative monetary conditions such as inflation being under control and the yield curve that hasn’t inverted yet, a flattening yield curve should not be high on the list of worries in comparison to other indicators.
Griffin Sheehy, Financial Analyst