If you’re wondering what a yield curve is and why there’s so much fretting in the U.S. over it flattening — and what that even means — you’re not alone. In November, Google searches for “yield curve flattening” shot up to their highest level in over a decade, only to reach an even loftier peak in April. Here’s what the fuss is about.
1. What’s a yield curve?
It’s a way to show the difference in the compensation investors are getting for choosing to buy shorter- or longer-term debt. Most of the time, they demand more for locking away their money for longer periods, with the greater uncertainty that brings. So yield curves usually slope upward.
2. What’s a flat yield curve?
A yield curve goes flat when the premium, or spread, for longer-term bonds drops to zero — when, in other words, the rate on 30-year bonds is no different than the rate on five-year bonds. If the spread turns negative, the curve is considered “inverted.”
3. Why does it matter?
The yield curve has historically reflected the market’s sense of the economy, particularly about inflation. Investors who think inflation will increase will demand higher yields to offset its effect. Since inflation usually comes from strong economic growth, a sharply upward-sloping yield curve generally means that investors have rosy expectations. An inverted yield curve, by contrast, has been a reliable indicator of impending economic slumps, like the one that started about 10 years ago. In particular, the spread between three-month bills and 10-year Treasuries has inverted before each of the past seven recessions.
4. What’s been happening with U.S. yield curves?
The flattening trend that took the market by force at the end of 2017 has only continued so far in 2018, with the Federal Reserve raising interest rates in March and June and signalling two more hikes by year-end. The spread between two-year and 10-year notes is about 34 basis points, less than half of what it was a year ago. (A basis point is one one-hundredth of a percentage point.) The spread between five-year and 30-year bonds, which was 96 basis points 12 months ago, has narrowed to around 28 basis points.
5. Does it matter which maturities you look at?
Yes. Generally, the closer the maturities, the narrower the yield spread between them. That also means that some parts of the curve tend to invert before others. More specifically, the spread between 7- and 10-year yields dipped to as low as 2 basis points earlier this year. Once that difference turns negative, other parts of the curve tend to invert within 6 to 28 days, according to BMO Capital Markets, which called it “the proverbial canary in a coal mine.”
6. Why is the curve flattening now?
There are lots of theories and no shortage of factors. On one hand, the Fed is steadily increasing short-term rates in response to the economy growing at a moderately strong pace. And unlike in previous years, there’s no indication that market turbulence will cause central bankers to deviate from their path. At the same time, America’s trade spats and concerns about growth outside the U.S. is helping to keep a lid on long-term yields, which have retreated from multi-year highs. Two other possible reasons: Pension funds and insurers have developed an insatiable demand for long-term, high-quality bonds, and the European Central Bank and Bank of Japan continue to have loose monetary policies. Both of those developments drive down those yields.
7. What do experts think will happen?
A growing chorus of fixed-income strategists on Wall Street expect yield spreads to keep shrinking in the years ahead. A handful expect the curve to flatten to zero or even invert sometime in 2018; others see that as more likely in 2019. Fed officials have expressed concerns about that scenario, but so far are doing little to prevent it from happening. And as long as the central bank is raising short rates, predictions of a steeper curve will remain in the minority.
