The shape of the yield curve—a graphical plot of the interest rate offered by U.S. Treasury bonds of various maturities—has been getting a lot of attention in recent months. Specifically, many commentators have been discussing “flattening” of the yield curve that’s occurred over the last year. Saying that the yield curve has flattened is just another way of stating that the difference between short-term interest rates (e.g., 2-year rates) and longer-term interest rates (e.g., 10-year rates) has narrowed. Exhibit 1 presented below clearly displays the flattening of the yield curve as well as the general rising in interest rates that’s taken place as the Fed has worked to normalize monetary policy. Note how the slope of the curve has flattened as short-term rates—displayed on the left side of the chart—have risen more substantially than have longer-term rates.
When gauging the shape (i.e., the steepness or flatness) of the yield curve, analysts typically evaluate the spread between the 10-year U.S. Treasury rate and the 2-year rate—what’s known as the “10-2 spread.” As of August 28, 2018, this spread stood at 0.21%. At the end of September 2017, the spread was 0.86%. Many market watchers have extrapolated this flattening into the future and used it as the basis for their prediction that the 10-2 spread will turn negative in the near future. If this were to happed (i.e., if short-term rates were higher than long-term rates), the yield curve would be said to be “inverted.”
The potential for an inverted yield curve has caused alarm bells to go off in some corners of the investing community as the shape of the yield curve has become a trusted signal of economic health due to the close historical relationship between yield curve inversions and subsequent recessions. More precisely, the yield curve has inverted prior to each of the last five recessions. This relationship is presented in Exhibit 2 which plots the 10-2 spread (green line) and U.S. economic recessions (grey shading). Yield curve (when the 10-2 spread has turned negative) inversions are highlighted in the chart with red circles. A cursory review of the chart reveals that the the curve has inverted prior to each recession.
Given this empirical relationship, it’s understandable that many investors have become nervous about the prospect of an inverted yield curve and have consequently questioned whether it makes sense to de-risk their portfolio. To this, we’d like to offer a few empirical observations that call into question the merits of using the shape of the yield curve as a bearish market timing tool.
First, it’s important to recognize that yield curve flattening is quite common during periods of Fed monetary policy tightening. This is due to the differing degrees of influence Fed monetary policy exerts on short- and longer-term rates. Fed monetary policy directly influences short-term interest rates such that when the Fed tightens monetary policy it’s common—and expected—to see short-term rates rise. Longer-term interest rates, on the other hand, are influenced by a variety of different forces but are generally thought to be most heavily influenced by inflation and growth expectations. During periods of monetary policy tightening, to the extent that market participants expect that the Fed’s policy tightening will be effective at containing inflation (i.e., not letting it accelerate significantly or uncontrollably), it’s natural to see longer-term rates remain well anchored. Such a combination of rising short-term rates and steady or only modestly rising longer-term rates results in a flattened yield curve which is precisely what we’re seeing today and is what we’ve witnessed during past tightening cycles.
Second, past experience has demonstrated that just because an inversion occurs, it doesn’t signal that a recession is imminent. In fact, on average, it has historically taken 645 days from the day the yield curve first inverted (following an earlier recession) to the official beginning of the subsequent recession (see Exhibit 3). What’s more is that there has been a considerable amount of variability around this average figure. Recessions have following yield curve inversions by as little as 323 days or by as many as 1,041 days.
Third, a yield curve inversion has not historically heralded poor near-term stock market performance. Looking back again at the last five recessions, we can observe that, on average, the S&P 500 Index gained 13% from the time the yield curve first inverted to when the subsequent recession ultimately began. Once again, there was considerable variability around this average. It’s interesting to note that despite this variability, in each episode, the stock market was actually up during the period between inversion and recession beginning.
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 Generally, longer-term interest rates are greater than shorter-term interest rates which when plotted on a standard graph (with maturities increasing from left to right on the horizontal axis and interest rates increasing from bottom to top along the vertical axis) appears gently upward sloping from bottom left to upper right.