Yield curve flattening and inversion: What is the curve telling us?
NEW YORK (March 29) - The U.S. Treasury yield curve has been flattening with parts of it inverting as investors price in an aggressive rate-hiking plan by the Federal Reserve as it attempts to bring inflation down from 40-year highs.
That has investors trying to guess whether it is signaling a recession is nearing.
The shape of the yield curve is a key metric investors watch as it impacts other asset prices, feeds through to banks' returns and has been an indicator of how the economy will fare. Recent moves have reflected investor worries over whether the Fed can tighten monetary policy to tame inflation without hurting economic growth.
Investors watch parts of the yield curve as recession indicators, primarily the spread between the yield on three-month Treasury bills and 10-year notes and the U.S. two-year to 10-year curve . However these two have veered in opposite directions, causing some confusion as to how accurate a recession signal they are giving. read more
Other parts of the curve are less-watched, such as the spread between five- and 30-year Treasuries which inverted on Monday and has also inverted prior to some recessions.
Here is a quick primer explaining what a steep, flat or inverted yield curve means and how it has in the past predicted recession, and what it might be signaling now.
WHAT SHOULD THE CURVE LOOK LIKE?
The U.S. Treasury finances federal government budget obligations by issuing various forms of debt. The $23 trillion Treasury market includes Treasury bills with maturities from one month out to one year, notes from two years to 10 years, as well as 20- and 30-year bonds.
The yield curve plots the yield of all Treasury securities.
Typically, the curve slopes upwards because investors expect more compensation for taking on the risk that rising inflation will lower the expected return from owning longer-dated bonds. That means a 10-year note typically yields more than a two-year note because it has a longer duration. Yields move inversely to prices.
A steepening curve typically signals expectations of stronger economic activity, higher inflation, and higher interest rates. A flattening curve can mean the opposite: investors expect rate hikes in the near term and have lost confidence in the economy's growth outlook.
WHAT DOES AN INVERTED CURVE MEAN?
The U.S. curve has inverted before each recession since 1955, with a recession following between six and 24 months, according to a 2018 report by researchers at the Federal Reserve Bank of San Francisco. It offered a false signal just once in that time.
The last time the 2/10 part of the yield curve inverted was in 2019. The following year, the United States entered a recession - albeit one caused by the global pandemic.
WHY IS THE YIELD CURVE INVERTING NOW?
Yields of short-term U.S. government debt have been rising quickly this year, reflecting expectations of a series of rate hikes by the U.S. Federal Reserve, while longer-dated government bond yields have moved at a slower pace amid concerns policy tightening may hurt the economy.
As a result, the shape of the Treasury yield curve has been generally flattening and in some cases inverting.
Reuters
