Do you know about the US Treasury yield curve and what it means for the economy?
If you don’t, here’s a quick primer. The US Treasury yield curve is a graph with treasury yields on the y-axis and maturities on the x-axis. It compares the yields between 3-month, two-year, five-year, and 30-year US Treasury debt. It is considered to be a benchmark curve for other debt in the market and a key indicator in predicting future economic growth.
Source: Investopedia
There are three general yield curve shapes: normal, flat, and inverted. Let’s see what each one implies for the economy.
- Normal: A normal yield curve with an upslope, such as the one depicted above, show that longer term bonds have higher yields compared to shorter term ones. This means that investors are confident that longer dated bonds will yield higher returns, corresponding to periods of economic expansion.
- Inverted: An inverted yield curve is the opposite of a normal yield curve and has a downslope. This means that the market has more faith in shorter term bonds compared to longer term ones, indicating a lack of confidence in the economy. Typically foreshadows an economic recession.
- Flat: In a flat or narrowing yield curve, the differences in yields between longer and shorter bonds begin to narrow. This happens as the yield curve is transitioning from normal to inverted and implies the economy is transitioning from expansion to contraction.
Just how accurate is an inverted yield curve at predicting an upcoming recession?
The answer is: very accurate.
Since the late 1960s, all seven economic recessions have been preceded by an inverted yield curve. The yield curve inverted twice since the start of the new millenium, once in 2000 and again in 2006, and we all know what happened after that.
Source: Business Insider
Notice how the shaded areas, representing recessions, are immediately preceded by the 2-year10-year spread going negative, indicating an inverted yield curve.
So knowing all that, where does the yield curve currently stand? Fortunately, it hasn’t inverted… yet. But it is flattening, and rapidly so. And one CNBC analysts predicts that it could invert as soon as the end of 2017. Here’s how the yield curve looks like at present.
Source: Business Insider
As you can see, spreads are rapidly narrowing. And a basic technical analysis of the yield curve dating back about 10 years, shows a double top pattern forming.
Source: Business Insider
Source: Investopedia
Because the spread failed to breach the double top, considered to be the resistance level, the most likely path next is to plunge way below the neckline. And since the subsequent drop is usually about equal to the top, in this case 145bps, spreads may drop all the way to -9bps.
The Federal Reserve hasn’t been helping the situation either. We have already mentioned in previous posts how its policy of hiking interest rates in a time of economic slowdown is foolish and counterproductive. When the Fed increases the federal funds rate, the yield curve flattens even more. This is because raising the rate pushes up short term rates more than long term rates.
Here’s a quick example: between June 2004 and June 2006 the Fed hiked the rate by 425 basis points. However, the 10-year note only went up 50 basis points! And with Yellen committed to continue raising interest rates, it may only be a question of when not if, the yield curve inverts.
As the CNBC article notes, there are only a couple things that may stop the yield curve from inverting. The first is a rapid unwinding of the Fed’s QE program; its $4.5 trillion balance sheet. The second is a rapid increase in GDP growth. Both of these scenarios look quite improbable; we should be prepared.
Intelligent investors are already preparing for just such an economic recession. They are diversifying their portfolio into assets that can not only weather, but thrive in such a recession. Assets such as gold and silver, traditional safe haven commodities that people flock to in such times.
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