Is the Yield Curve Flashing Green or Red?

By:Tim Bennett

Investors have started to get nervous about the shape of the US yield curve and what it may reveal about global markets. But are they right to be worried?

Anyone who follows the financial media cannot fail to have noticed all the discussion around the current shape of the US yield curve. So let’s take a quick look at why it is attracting so much attention and what it could mean for investors.

How it looks now

The pink line shows the current relationship between short, medium and long-term government bond (Treasury) yields in the US. You will notice that the line slopes gently upwards as you travel from right to left. This is considered “normal” since you would expect an investor to want a greater return (yield) for taking the risk of locking up their money for longer periods.

Why markets are nervous

The grey and black lines are on the chart above to show how its shape has changed since December 2016 and December 2013. What is happening is the curve is flattening – the “short” end is gradually rising to more or less match the “long” end, such that yields on short-dated government IOUs are becoming similar to those on much longer-dated ones. So what about the green line at the top?

That one represents a yield curve that is “inverted” such that short-term yields are above longer term ones. This is unusual in so far as it suggests investors no longer demand a time premium for investing. Now notice the date – this was the shape of the yield curve just ahead of the credit crisis of 2007-2009. In short, the yield curve inverted just before the wheels came off global markets. Some people are pointing to the flattening of the yield curve now and wondering whether it presages a similar downturn.

Why bond markets matter

“If they were bubbly, I sent them to work in equities and if they were bright I sent them to work in bonds. If they were neither, I despatched them to the corporate finance team.” So said the Head of Recruitment at a big bank a few years ago. The point? Bond markets are thought to be staffed with the brightest and most analytical people in the markets and they have a better track record than their equity peers when it comes to predicting downturns. That’s because although downturns might be bad for equities, they have historically often been good for bonds – as Central Banks cut rates, fixed income bond prices often rise.

Is a flattening yield curve a good or bad thing?

The truth, when it comes to interpreting the recent change in the shape of the US Treasury yield curve, is that no-one knows for sure what it signals this time around. After all we are looking at it following an era of unprecedented monetary stimulus (QE) and record-low interest rates. So the usual rules of interpretation may have gone out of the window.

Bulls will say that this recent flattening is just a predictable reaction at the short-end of the curve to the US Fed raising rates in the US. As the economy strengthens and inflation returns, a period of yield parity between short and longer dated securities is nothing to be alarmed about.

Bears, on the other hand, will point to the history of the yield curve flattening and look back at the instances where it lead to a full inversion. They worry that the bond market may be signalling tough times ahead as growth stalls. Should that happen, stimulus from Central Banks may even need to resume at some point. Bear in mind that if interest rates are expected to fall, rather than rise, then long-dated bonds, carrying a fixed rate of interest, become more attractive: as flight-to-safety buyers move in, prices rise and yields fall. This pushes the right hand end of the yield curve down.

The conclusion

At this stage, although the yield curve is flatter than it has been for a while, it is still some way off a full inversion. Further, a flat yield curve has not always coincided historically with the beginning of a downturn. Moreover, the old relationship between Central Bank action and the shape of the curve may have been muddied over the last decade to the point where it is dangerous to work with outdated assumptions. Nonetheless, given its importance as an indicator in global markets, it remains a chart that will be closely monitored during the second half of 2017.