Flattening of the yield curve
A yield curve tracks the yields of Treasury securities maturing at different time periods. For example, usually, the yield of two-year securities (SHY) is lower than that on the ten-year security (IEF) (TLT). The narrowing of the difference between these yields is usually referred to as the “flattening of the yield curve.” The more concerning thing is when the yield curve (BND) inverts, which means that the yields on shorter duration securities increase those on the longer-term securities. The inversion of the yield curve has been a good indicator of an upcoming recession in the past.
Therefore, it doesn’t come as a surprise that Wall Street is concerned about a potential slowdown, as the spreads have significantly narrowed between the two-year and ten-year Treasury yields. The current difference between the two-year and ten-year Treasury yields is 0.34 percentage points, which is closer to the levels seen in 2007, which was soon followed by a recession. The Fed’s rate hikes lead to further flattening of the curve, as higher rates increase the short-term rates. The markets are therefore concerned that two more possible hikes this year could lead to an inverted curve.
Inversion of yield curve and possible recession
According to research from the San Francisco Fed, the inversion of the curve has “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.” The prediction of the timing of a recession after the inversion, however, is not sacrosanct, as it has occurred after as close as six months and as long as two years after the inversion.
While there is a case to be made about the inverted yield curve predicting a possible recession, market participants are also citing investors’ estimates of rates and the lingering impact of the Fed’s previous asset purchases as possible reasons that the yield curve might have lost some of its predictive power. Whatever the case may be, as markets grow more and more concerned about the inverted yield curve and a possible recession, the loop keeps getting stronger. Moreover, it is almost a consensus now that there may only be a little upside to the markets left, if at all. Thus, gold (GLD) (SGOL) and other precious metals could help mitigate the risks and uncertainty in case of a major slowdown.