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Why the Yield Curve’s Flattening Doesn’t Indicate a Recession

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Flattening yield curve not a sign of recession

In recent months, there’s been a lot of chatter about the flattening of the yield curve. The yield curve is constructed by plotting the yields of different maturities, and it gives investors an idea of the expected path of interest rates in the near (SHY), medium (IEF), and long terms (TLT).

Back-tested data suggest that the changes in the yield curve have worked as forward indicators for changes in economic cycles. In a normal economy, the yield curve is upward sloping, which means that long-term interest rates (BND) are higher than short-term rates.

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As investors’ growth and inflation (TIP) expectations fall, long-term yields tend to fall faster than short-term yields, resulting in the flattening of the yield curve and eventually leading to an inverted yield curve. For more information, read Is a Flattening Yield Curve a Sign of an Impending Recession?

Yield spreads used in The Conference Board LEI

The Conference Board Leading Economic Index (or LEI) incorporates the interest rate spread between the 10-Year US Treasury Bonds (GOVT) and the federal funds rate, the overnight interbank lending rate. 

According to the board’s July 20, 2017, report, the interest rate spread for June was 1.2%, a fall compared to 1.4% in May. This spread has narrowed consistently from 2.0% in December 2016. The net contribution of this yield spread to the LEI fell from 20% in December 2016 to 13% in June 2017.

Do we need to be worried about this financial metric?

This yield spread signals a recession when it’s below zero. At this point, there’s no cause for concern, as it could take many years for yields to narrow and invert the curve. All investors need to do is monitor these yields closely for any signs of an economic slowdown.

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