Flattening of the yield curve
A yield curve tracks Treasury securities’ yields that are maturing at different times. For example, two-year securities’ (SHY) yields are usually lower than ten-year securities’ (IEF) (TLT) yields. The narrowing of the difference between the yields is usually referred to as the “flattening of the yield curve.”
The yield curve mainly reflects bond market investors’ expectations of the Fed’s actions and future economic conditions (SPY) (IVV). The current shape of the curve implies that the bond market expects a weaker outlook for 2019 and lower inflation.
Last month, the difference between ten-year and two-year Treasury yields hit 19.75 basis points—the lowest level since August 2007. Currently, the spread is at 25.0 basis points. Since the Fed seems ready to hike the short-term rates by another 25 basis points in September, the yield curve might become inverted.
The Fed and yield curve
Fed officials are divided on the yield curve’s significance in predicting recessions. While officials concur with this logic and want the Fed to pause rather than risk causing an inversion, others argue that a number of global factors, like central banks’ asset purchase programs, might have led to the compression in term premiums. These officials think that the significance of an inverted yield curve might have declined compared to historical records. Other factors, including tight labor market data, support the Fed increasing the rates. According to Oxford Economics economist Kathy Bostjancic, “The number of current voting members in the hawkish camp is rising and far outnumbers those in the dovish camp.”
Inverted yield curve and a possible recession
Whether the inverted yield curve remains a reliable predictor of a recession is debatable. As more investors and market participants start worrying about the possible inversion and an economic slowdown, the loop strengthens and becomes a self-fulfilling prophecy.