Over the past few months, the “yield curve” has often been mentioned in newspapers and television reports about the U.S. economy. Reporters mention how the yield curve has flattened and recently, inverted. While the conclusion is usually simply made that an inverted yield curve = upcoming recession, this letter will attempt to shed a more nuanced light on what exactly the yield curve is, how it’s changed over the past five years, and what that could mean for the U.S. economy going forward.
Understanding The Yield Curve
When investors say the “yield curve”, they are commonly referring to a comparison of the various yields of treasury bonds for different maturities, such as a 3-month Treasury Bill, a 5-year Treasury Note, or a 10-year Treasury Bond. If you plot all the various maturities on a graph, from 3-months to 30-years, you have yourself a yield curve.
If you look at the dashed grey line in Exhibit A, you can see what the Treasury yield curve looked like at the end of 2013. The shape of the yield curve then was upward sloping, meaning short-term maturities yielded less than long-term maturities (such as 0.38% for a 2-year Treasury compared to 3.04% for a 10-year Treasury.) This upward-sloping yield curve is what we typically see. Since 1976, the 10-year Treasury has yielded more than the 2-year Treasury over 85% of days.
Exhibit A – U.S. Treasury Yield Curve
The reason the yield curve is typically upward sloping is subject to much debate by academics and market participants, however, the most common reason is that investors demand higher yields for longer maturity bonds due to the higher risk involved, both from defaults and interest rate sensitivity. An example of this risk is that you may loan a friend money for 3-months at a low interest rate but for a 30-year loan, that’s another story…
Recent Changes In The Yield Curve
In viewing Exhibit A, you’ll also note the current yield curve, in blue, looks quite different than it did almost six years ago. Since 2013, the yield curve has flattened, with the yield of 2-year and 10-year Treasuries now almost being equal (1.61% vs. 1.62%) and inverted at the shorter end of the curve with 3-month Treasuries yielding more than 1-year through 10-year Treasuries.
To view the relative steepness, or flatness, of the yield curve, we can look at the difference between the 2-year and 10-year Treasury yields as shown in Exhibit B. A higher difference, means the yield curve is steeper, a lower (or negative) difference means the yield curve is flatter or inverted. As you can see, over the past six years, the yield curve has steadily become flatter with 2-year yields almost rising above 10-year yields this week.
There are numerous reasons for a typical flattening of the yield curve but one of the largest is that investors believe interest rates will be lower in the future. Thus, while they may have demanded 3.0% for a 10-year Treasury six years ago, they’ll take 1.6% today because they believe future interest rates will be even lower.
Exhibit B – Difference in 10-Year Treasury Yield vs. 2-Year Treasury Yield
The typical drivers of lower future interest rates are economic weakness, the Federal Reserve lowering interest rates, and lower than average inflation. However, even in the absence of a view on the economy and the upcoming actions of the Federal Reserve, many believe the yield curve is flashing warning signs because flat to inverted yield curves have often preceded recessions. In Exhibit B, you’ll note the past three recessions (shaded in grey) have been preceded by an inverted yield curve and we’re heading in that direction very quickly.
So What Should You Do?
Investors should use the flashing warning sign of the yield curve to pay close attention to economic data as we approach the latter stages of this cycle. While the recession may not arrive tomorrow, we’re most likely closer to the end of this expansionary period than we are to the beginning and it can pay to position your portfolio for the eventual shift.
Pay close attention to the duration of your fixed income as well as the relative weight you have in fixed income compared to equities. We favor short-term bonds currently and equities over fixed income.
It’s important to note an inversion doesn't necessarily mean a recession is imminent. In the past three recessions, we’ve seen an inverted curve precede the recession by more than two years. Said another way, just because it’s cloudy, it doesn’t mean it’s going to rain, yet, it will rain eventually…
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