Flat yield curve
While the yield curve is normally upward-sloping, it might flatten excessively in certain special conditions. “Flattening” refers to the contraction of differences in yields across maturities. A flat yield curve signifies that investors are indifferent towards maturity profiles of the Treasuries.
After steady expansion in the 1980s, inflation started rising and the Fed increased short-term interest rates from 1986 to 1989, resulting in a narrowed gap between short- and long-term bond yields to such an extent that the long-term yields fell lower than short-term yields. For 99 trading days out of 250 in 1989, the yield on the three-month T-bill (BIL) was higher than the yield on the ten-year Treasury note (IEF).
After remaining inverted for a significant portion of 1989, the yield curve started normalizing again, resulting in a flattening yield curve in late 1989 and early 1990.
The flattening of the yield curve in late 1989 and early 1990 preceded a short recession from July 1990 to March 1991.
Investors should look for the underlying context when they encounter a flat yield curve. If the yield curve is flattening—that is, if the yield curve is migrating from normal to inverted, the difference between yields on short-term bills and long-term bonds may soon turn negative. In this case, investing in longer-term bonds (TLT) is preferable over short-term bond investments (BIL), as the yields on short-term bonds will be higher, leading to lower prices. Bond prices and yield share an inverse relationship.
Some investors argue that the inverted yield curve is an indicator of economic recession. So investors should stay away from investment-grade bonds (LQD) and high yield bonds (HYG) if the yield curve is inverting. An economic recession will hamper corporate profitability, leading to widening credit spreads and yields. As yields and prices share an inverse relationship, corporate bond prices may fall if a recession follows.
On the other hand, if the yield curve is flattening after inverting, long-term yields may rise. So investors should prefer staying invested in short-term bonds in that case.
To find out about the inverted yield curve, move on to the next part of this series.