Should We Fear the Curve - July 16, 2018

The yield curve has turned into the flavor of the month. A quick look at Google Trends shows a significant increase in recent searches for the term, which brings us to two important questions: What is the yield curve? And why has it been thrust into the financial headlines?

First question – the yield curve is simply a plot of the yield of a particular class of bonds at various maturities; for example, Treasury bonds.

Most analysts look at Treasuries and plot the yield on a graph from 3 months to 30 years and compare returns. Normally, the yield increases as the maturity increases, i.e., a 10-year Treasury bond yields more than a 2-year Treasury, and a 2-year more than a 3-month T-bill.

The keyword is “normally.” There are times when the yield curve inverts, i.e., longer-dated bonds yield less than shorter-dated bonds. This is important because an inverted yield curve has historically been an excellent indicator of an oncoming recession (Figure 1), which helps to answer the second question.

One popular metric used by analysts looks at the difference between the yield on the 10-year Treasury and the 2-year Treasury.

As of July 13, the 10-year Treasury yielded just 0.24 percentage points more than the 2-year. You can see in Figure 1 that the curve turned negative prior to each of the last five recessions (shaded in red below). Put another way, we haven’t experienced a recession with a normally sloped yield curve.

So, how worried should we be?

7 16 18 10 year yield

The table below highlights key metrics, suggesting a near-term recession is unlikely. For example, the last time the yield on the 2-year Treasury first exceeded the 10-year Treasury occurred on December 27, 2005. A recession didn’t ensue for another 24 months. The S&P 500 Index peaked 22 months after the inversion, rising 24.6%.

7 16 18 second yield curve

Using the last five recessions as our guide (1980 – 2008), a recession occurred on average 20.8 months after the yield curve inverted, the S&P 500 Index peaked on average nearly 17 months after the curve inverted, and rose on average 24.5% before the onset of a bear market (all data from St. Louis Federal Reserve).

There is one more wrinkle. Although the curve has yet to invert, Fed officials have been debating the importance such a signal might send. Is this an airtight economic indicator or are other factors in play?

For example, are U.S. yields artificially depressed by extremely low yields in Europe and Japan, which may be encouraging some overseas investors to buy U.S. bonds (bond prices and bond yields move in the opposite direction)? There isn’t a clear-cut answer right now.

Bottom line—an inverted yield curve shouldn’t be something we brush aside. But the data going back to the late 1970s signaled such an event was not an imminent signal of a recession.