By Dr. Sonu Varghese via Iris.xyz
A lot of investor attention is now focused on the yield curve, which has flattened considerably over the past several weeks. Since an inverted yield curve is typically a strong recessionary signal, the fear is that we may be close to a recession. However, other macro economic data suggests that is not the case.
Our own research into this topic finds that yield curve compression by itself is not indicative of a recession. Only inversion is, and that too when the Federal Reserve (Fed) is simultaneously raising the federal funds rate.
Yet a flattening yield curve is not a positive sign for the economy. It pushes investors to become more defensive – risk premia for long-term investments reduce and investors are comfortable parking money in short-term instruments. Profit margins also reduce for banks, which are a key conduit for credit growth.
The spread between 10-year treasury yields and 3-month (10y-3m) and 2-year yields (10y-2y) are now at their lowest levels since 2007. The 10y-3m spread has compressed 88 basis points (bps) in 2017, while the 10y-2y spread has shrunk by 68 bps (as of December 12th). Most of the compression occurred in the first half of the year and so this is not a recent phenomenon.
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