The Yield Curve Is Inverted! Remind Me Why I Care

(Bloomberg) -- If you’re wondering what a yield curve is and why there’s so much fretting in the U.S. over it flattening -- and parts of it even inverting -- you’re not alone. Late last year, Google searches for “yield curve flattening” shot up to their highest level in over a decade, only to reach an even loftier peak in April. Inversion supercharged those inquiries. Here’s what the fuss is about.

1. What’s a yield curve?

It’s a way to show the difference in the compensation investors are getting for choosing to buy shorter- or longer-term debt. Most of the time, they demand more for locking away their money for longer periods, with the greater uncertainty that brings. So yield curves usually slope upward.

2. What are flat and inverted yield curves?

A yield curve goes flat when the premium, or spread, for longer-term bonds drops to zero -- when, for example, the rate on 30-year bonds is no different than the rate on two-year notes. If the spread turns negative, the curve is considered “inverted.”

3. Why does it matter?

The yield curve has historically reflected the market’s sense of the economy, particularly about inflation. Investors who think inflation will increase will demand higher yields to offset its effect. Because inflation usually comes from strong economic growth, a sharply upward-sloping yield curve generally means that investors have rosy expectations. An inverted yield curve, by contrast, has been a reliable indicator of impending economic slumps, like the one that started about 11 years ago. In particular, the spread between three-month bills and 10-year Treasuries has inverted before each of the past seven recessions.

4. What’s been happening with U.S. yield curves?

The flattening trend that took the market by force at the end of 2017 has continued through 2018, with the Federal Reserve raising interest rates in March, June and September and signaling another hike before the end of the year. The spread between two-year and 10-year notes is about 12 basis points, with a basis point being one one-hundredth of a percentage point. That’s down from 79 basis points in February. Some segments of the yield curve inverted for the first time in more than a decade.

The Yield Curve Is Inverted! Remind Me Why I Care

5. Does it matter which maturities you look at?

Yes. Generally, the closer the maturities, the narrower the yield spread between them. That also means that some parts of the curve tend to invert before others. More specifically, the spreads between Treasuries maturing in two years and three years, two years and five years, and three years and five years all fell below zero in December.

6. Why is the curve flattening now?

There are lots of theories and no shortage of factors. On one hand, the Fed is steadily increasing short-term rates in response to the economy growing at a moderately strong pace. And unlike in previous years, central bankers seem less willing to deviate from their path because of market turbulence. At the same time, America’s trade spats and concerns about growth outside the U.S. are helping to keep a lid on long-term yields, which have retreated from multi-year highs. More recently, Fed speakers have shifted their tone, sounding less sanguine about America’s outlook. Two other possible reasons: Pension funds and insurers have developed an insatiable demand for long-term, high-quality bonds, and the European Central Bank and Bank of Japan continue to have loose monetary policies. Both of those developments drive down those yields.

7. What do experts think will happen? 

With some spreads already below zero, all eyes are on the three-month, 10-year curve that has anticipated recessions. Treasury Secretary Steven Mnuchin said he doesn’t see the market as an indicator of the economy’s future. Fed officials have expressed concerns, but so far are doing little to prevent inversions of additional segments of the curve. And as long as the central bank is raising short rates, predictions of a steeper curve will remain in the minority.

The Reference Shelf

  • A Bloomberg News overview of the factors that might be flattening the curve.
  • A Federal Reserve Bank of San Francisco paper on the squeeze on the yield curve.
  • Frequently asked questions on the yield curve from the Federal Reserve Bank of New York.

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