Flattening US Treasuries Yield Curve: Is It The Economy's Canary in the Coal Mine?

The US treasuries yield curve is 'flattening'. Is it the economy's canary in the coal mine? Bond yields in general reflect the amount of return an investor realizes on a bond investment and US treasury yields are usually directionally linked to interest rates. Given the 'yield curve's' significance as a key sentiment indicator for the economic outlook, it warrants a closer look as such. 

 

Yield curve is a graphical representation of bond yields of varying maturity dates. Typically, longer the maturity, higher the yield.

The yield-curve represents the graphical shape of bond yields plotted against the maturity of these bonds. Typically, longer the maturity of a bonds, higher is the yield that it carries and is described as the 'normal yield-curve' (discussed below). The US treasuries yield curve (often simply referred to as the 'yield curve') is a closely tracked visual representation offering meaningful read-throughs. US treasury bonds are considered the safest investment in global financial markets and their yields are extensively used for wide-ranging economic inferences. Yields are often thought of as a proxy for bond investors appetite for risk. Higher the expected risk, higher the yield and so on. 

 

It is usually characterized by the following shapes i) Normal yield-curve ii) Flattening yield-curve and iii) Inverted yield-curve. Depending on the shape of the curve, there are some inferences that can be drawn on the economy, albeit not easy to individually isolate the key drivers. 

i) Normal yield-curve: Short-term bonds carry lower yields while long-term bonds carry higher yields (and the difference between these yields is the yield spread). This is fairly intuitive, hence 'normal', since the longer a bond investors capital is locked in, the higher the yield that an investor warrants. Therefore, normal curve takes the shape of a upward sloping curve with yields rising as maturity period increases.

ii) Flattening of the curve: The 'flattening' of the yield curve is not technically a shape but simply means that the yield spread is decreasing. The term 'flattening' is again a graphical representation where in the steepness of the curve is somewhat flattening. It essentially means that the difference between the long-term and short-term treasury yields is narrowing.

iii) Inverted Yield Curve: This happens when the short-term yield moves higher than long-term yield. While this appears counter-intuitive, what it signifies is that bond investors now see the current interest rate environment as more attractive to lock in prevailing rates under the expectation that future rates might actually be lower than what it is now. In effect, investors ask for a higher rate of return on short term lending relative to long term which is seen as red-flag for a possible period of economic slowdown. 

 

The current US treasury yield-curve is flattening i.e. current yield spread is narrowing. The yield-spread stands at c. 23bp and there are concerns of a yield-curve inversion. A flattening/inverting yield curve is often perceived to be indicative of an upcoming recession, with investors increasingly being hesistant to lend in the short term.

This flattening yield-curve typically signifies cautiousness surrounding the US economic outlook. It stands at a tight 23bp at the time of writing. In case this spread further narrows to zero or worse goes negative, we will have the inverted yield curve. In the last 50 years, almost always has an 'inverted yield curve' given way to recession. In that context, the yield curve is being closely watched and has prompted a response from Fed Chairman, Jerome Powell who albeit played down concerns and said "there’s no reason to think that the probability of a recession in the next year or two is at all elevated." The short-term yields are a direct result of interest rate hikes by the federal reserve whereas the longer-term yields are indicative of growth and inflation expectations.  

 

There are other factors at play ranging from inflation expectations to general demand for US treasury bonds that impact their yields; Higher demand for US treasury bonds pressure their yields. Other factors are at play ranging from inflation expectations to a general demand for US treasury bonds.

As touched on earlier, longer-term yields typically track growth and inflation expectations. This is again intuitive since bond coupons can see their value eroded via inflation. In that context, lower long-term yield also underlines lower expectations of inflation. However, if the demand for long-term bonds increases via asset managers or even foreign funds/governments buying US long-term debt, this could artificially pressure long-term bond yields. As outlined earlier, there are several moving pieces to the economy (click here to understand more on the nuances of inflation, interest rates,  monetary policy etc) and the shape of the yield-curve is just one economic tool, albeit one that is closely watched by the financial markets and other industry participants. With US mid-term elections in November, rest be assured, the term yield curve will be thrown around extensively in conjunction with any commentary around the economic outlook of the US.  

 

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