Thursday, 13 Dec 2018
Business

The Yield Curve Is Inverted! Remind Me Why I Care

If you're wondering what a yield curve is and why there is so much in the US – and you are not alone. Late last year, Google searches for "flattening yield curve" to view their highest level in a decade, only to reach an even higher loftier peak in April. Inversion supercharged those inquiries. 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 to buy to buy short- or long-term debt. Most of the time, they demand more for locking their money for longer periods. So yield curves usually slope upward.

2. What are flat and inverted yield curves?

A yield curve goes flat when the premium, or spread, for long-term bonds drops to zero – when, for example, the rate on 30-year bonds is no different than the rate on two-year notes. 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, especially about inflation. Investors who think inflation will increase their demand. Because of a strong economic growth, a sharply upward-sloping yield curve 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 11 years ago. In particular, the spread between three-month bills and 10-year Treasuries has been inverted before the seven recessions.

4. What's been happening with U.S yield curves?

The flattening trend that took the market by force of the end of 2017 has continued through 2018, with the Federal Reserve, March, June and September. The spread between two-year and 10-year notes is about 12 basis points, with a basis point being one-hundredth of a percentage point. That's down from 79 basis points in February. Some segments of the yield curve inverted for the first time in a decade.

5. Does it matter which maturities you look at?

Yes. Generally, the closer the maturities, the narrower the yield spread between them. Which also means that parts of the curve tend to be inverted before others. More specifically, the spreads between Treasuries maturing in two years and three years, two years and five years, and three years and five years all fell below zero in December.

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 in a moderately strong pace. And unlike in previous years, central bankers seem less willing to deviate from their path because of market turbulence. At the same time, America's trade spats and concerns about growth outside the United States are helping to keep a lid on long-term yields, which have retreated from multi-year highs. More recently, Fed speakers have shifted their tone, sounding blood less about America's outlook. 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 continues to have loose monetary policies. Both of these developments drive down those yields.

7. What do experts think will happen?

With some spreads already below zero, all eyes are on the three-month, 10-year curve that has anticipated recessions. Treasury Secretary Steven Mnuchin said he does not see the market as an indicator of the economy's future. Fed officials have expressed concern, but are doing little to prevent inversions of additional segments of the curve. And as long as the central bank is rising short, predictions of a steeper curve will remain in the minority.

To contact the reporter on this story: Brian Chappatta in New York at bchappatta1@bloomberg.net

To contact the editors responsible for this story: Benjamin Purvis at bpurvis@bloomberg.net, John O'Neil

© 2018 Bloomberg L.P.

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