Is the Yield Curve Flashing Green or Red?
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?
How it looks now
Why markets are nervous
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
Is a flattening yield curve a good or bad thing?
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.