You may or may not have already heard that the U.S. treasury yield curve is at its flattest since 2007 – the year before the 2008/09 Global Financial Crisis. Is this a potential sign of things to come?
But before I delve into that, I guess a bit of background information is in order.
What is the yield curve?
The yield curve shows the spread (difference) between the interest rates of short-term and long-term U.S. Treasury bonds. For example, the current interest rate (as at 28 June 2018) for the 10-year U.S. Treasury bond is 2.83% and the interest rate for the one-year U.S. Treasury bill is 2.33%, therefore the spread is 0.5 percentage points.
Usually, interest rates for long-term bonds are higher than for short-term bonds. And rightly so because investors demand a higher yield for locking their money away for a longer period of time, which brings greater risk and uncertainty. In this case, the yield curve is ‘normal’ and slopes upward.
But when the spread between long-term and short-term yields starts to narrow — either by long-term yields falling and/or short-term yields rising — then the yield curve becomes flatter.
If long-term yields become even lower than short-term yields (which obviously doesn’t make sense in the long run), then the spread becomes negative and the yield curve is ‘inverted’ and slopes downward.
So what happens when the yield curve is inverted?
Historically whenever the yield curve becomes inverted, it is a strong signal that the U.S. is about to enter a recession. Have a look:
Source: Federal Reserve Bank of San Francisco
The chart above is the yield curve spread between the 10-year and one-year U.S. treasury yields from January 1955 to February 2018. The grey areas indicate periods of recession. As you can see, every U.S. recession in the past 60 years has been preceded by an inverted yield curve (i.e. the spread goes below zero). Amazing, really.