The flattening yield curve: Bad omen or "much ado about nothing"?

E*TRADE Securities2

05/24/18

Let’s face it. Holding court on the Treasury yield curve isn’t going to blow back anyone’s hair at a cocktail party. But in the financial markets, yield curves are something of a big deal.

And that's because the Treasury yield curve is behaving in ways that may make some investors nervous. Namely, the curve is flattening. In fact, as recently as April 11, the yield spread between two- and 10-year Treasury notes was the narrowest it's been in nearly 11 years at 0.43%. On that same date in 2017, the spread was 1.08%.1

So what’s the big deal? Well, 11 years ago was 2007—the dawn of the great recession.

What does the shape of the yield curve signal?

First, some perspective on how a yield curve is typically shaped. A "normal" yield curve slopes upward, with short-term rates lower than longer-term rates. This is because investors generally demand a premium to hold debt for longer periods of time. An upward-sloping yield curve assumes that long-term yields will continue to rise, and is generally indicative of a healthy, growing economy.

An inverted yield curve assumes just the opposite—that short-term Treasury yields will exceed longer-term yields. Under this scenario, investors are generally willing to hold longer-dated Treasury bonds, rather than continually reinvest in short-term Treasury bills that may lose value.

Which brings us full circle.

The risks of an inverted yield curve

The reason a flattening yield curve unnerves so many investors is that an inverted yield curve has historically been a predictor of a recession. In fact, an inverted Treasury yield curve has preceded all nine US recessions since 1955, according to a recent study conducted by the Federal Reserve Bank of San Francisco.2 Little wonder, then, that the flattening yield curve is a trending topic of late.

Monetary policy could exacerbate flattening

But is this concern misplaced? It all depends on your perspective.

If you believe the yield curve has flattened largely because of monetary policy, then the Federal Reserve's near-term plans could make you nervous. The Fed's own minutes indicate that members of the FOMC—the Fed's policy-making arm—expect to hike the fed funds target rate by at least an additional 50 basis points in 2018, which could exacerbate flattening as the Fed Funds rate is typically linked closely to the short end of the curve.3

But is the Federal Reserve really in danger of leading the country into recession? Given the scale of recent quantitative easing and today's historically low interest rates, the Fed has so far shown an accommodative bias.

A new normal for the yield curve?

Also consider this: As the Fed manages its balance sheet, the Treasury Department—anticipating higher budget deficits as a result of recently enacted tax cuts—is emphasizing shorter-term debt issuance.4 More short-term borrowing could create scarcity on the long end of the curve, driving up prices of longer-dated Treasuries and lowering their yields. While this, too, can lead to a flatter yield curve, it is arguably more reflective of potential budget deficits than a foreshadowing of recession.

What are possible effects?

Those who believe a flattening yield curve is a bad omen may find solace in traditionally more defensive sectors such as utilities and health care as well as certain consumer subsectors like food products and staples. And they may consider rotating out of banks, which make money by borrowing at short-term rates and lending at longer-term rates. But those investors who believe all is mostly well may wish to stay focused on what they’re already doing—that is to say, investing in a diversified portfolio of stocks and bonds, mapped towards one’s goals, risk tolerance, and time horizon.

Keep in mind that a flattening yield curve isn't the same as an inverted yield curve. It's somewhere between normal and scary. And some would likely argue that’s a pretty good description for the United States in 2018. The FOMC meets next on June 12. What happens at that meeting could keep the yield curve dialogue interesting—depending, of course, on what you consider interesting.


1. U.S. Department of the Treasury. Daily Treasury Yield Curve Rates as of May 23, 2018. www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

2. Bauer, Michael D. and Mertens, Thomas M. "Economic Forecasts with the Yield Curve," Federal Reserve Bank of San Francisco, Mar. 5, 2018, www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve

3. Board of Governors of the Federal Reserve System. FOMC Projections materials. Mar. 21, 2018. https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20180321.htm

4. Timiraos, Nick. "Treasury's New Approach to Debt: Go Short," The Wall Street Journal, Nov. 16, 2017. https://www.wsj.com/articles/treasurys-new-approach-to-debt-go-short-1510782803