Fed Officials Are Divided on the Significance of the Yield Curve



The significance of the yield curve

While most Fed officials agreed on the need to keep raising rates and the concerns posed by the trade disputes, there was disagreement among them regarding the significance of the yield curve.

Some participants argued that in the United States (SPY) (IVV), the inverted yield curve has often preceded recessions. Therefore, policymakers should consider the slope of the yield curve while assessing economic and policy outlooks.

Others suggested that a number of global factors, such as central banks’ asset purchase programs, may have led to the compression in term premiums. As such, they think that the significance of an inverted yield curve may have declined compared to historical records.

Flattening of the yield curve

A yield curve tracks the yields of Treasury securities maturing at different times. For example, usually, the yields of two-year securities (SHY) are lower than those of ten-year securities (IEF) (TLT). The narrowing of the difference between yields is usually referred to as the “flattening of the yield curve.”

When the yield curve (BND) inverts, it means that the yields of shorter-duration securities become larger than those of longer-term securities. The inversion of the yield curve has been a good indicator of upcoming recessions in the past.

Inversion of yield curve and possible recession

Wall Street, therefore, is understandably 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 0.24 percentage points, close to the levels seen in 2007, which was soon followed by a recession.

The Fed’s rate hikes lead to a further flattening of the curve, as higher rates increase short-term rates. The markets are therefore concerned that two more possible rate hikes this year could lead to an inverted curve.

Whether the inverted yield curve remains a reliable predictor of recession is debatable, but as markets grow more and more concerned about the inverted yield curve and a possible recession, the loop keeps getting stronger. Moreover, it’s almost a consensus now that there may be little, if any, upside left in the markets. Thus, gold (GLD) (SGOL) and other precious metals could help mitigate the risks and uncertainty in the event of a major slowdown.

Now that the Fed’s minutes are out, the markets will look forward to the Fed Symposium, at which Fed chair Jerome Powell could provide further insight into the issues facing the economy. For more on this topic, read Fed Symposium Focus: Trade, Emerging Markets, Rates?

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