What are yield spreads?
Yield spreads refer to the difference between the yields of two fixed income securities. They can either be of the same or different credit quality. In this article, we’ll look at yield spreads between Treasury securities. Spreads are measured in basis points. One basis point is one-hundredth of a percentage point, so 1.0% = 100 basis points.
Broadly speaking, rising—or widening—spreads lead to a positive yield curve, which indicate anticipated stable economic conditions. On the other hand, contracting—or falling—spreads may indicate worsening economic conditions, resulting in a flattened yield curve.
A bit of history
In the graph above, we have provided spreads between the two-year and ten-year Treasury notes. Spreads by this measure remain below 150 basis points.
In comparison, they had risen to as high as 290 basis points in February 2011. This indicates that the yield curve is much flatter than it was four years ago. Spreads had risen to 175 basis points in July 2015, but they have fallen since then.
Can the yield curve become inverted?
An inverted yield curve is possible, especially if the rate hike is not accompanied by a rise in inflation expectations. These expectations are a key driver not only for Treasuries but also for investment-grade bonds and related mutual funds like the Oppenheimer Core Bond A (OPIGX) and the Vanguard Total Bond Market Index (VBMFX). VBMFX invests in bond issues of companies like Allergan PLC (AGN), American Airlines Group (AAL), and Oracle (ORCL).
Although an inverted yield curve generally heralds a recession, this may not always be the case. The laws of supply and demand can also be responsible for an inverted yield curve. A short-term inversion of the yield curve may just indicate a market adjustment to a rising interest rate regime. A sustained drop in spreads, however, is another matter.
In the final article of this series, let’s revisit the Fed’s reasons for its hawkish tone in its October 2015 statement. We’ll also look at possible deterrents that could defer the rate hike to 2016.