The US Treasury yield curve — the graphical representation of the relationship between bond maturities and their yields — is flattening. Some maturities, such as yields on two to five-year bonds, has already inverted. An inversion of the two and the ten-year maturities, recognized in the financial world as a warning sign of coming recession, is poised to flip sometime early next year.
Below can be found a graph showing the trend of the difference between the ten-year and two-year rates. The fact that the value is approaching zero shows that the two-year rate is rising to meet a ten-year rate that is following. Remember that when demand for a bond increases, its yield will fall. So, a falling yield on ten-year notes evidences a spike in demand for longer-term bonds, while the corresponding rise in yields for two-year treasuries is evidence of a flight our of short-term bonds.
The yield curve generally slopes upward because investors expect higher yields on long-term investments. Their money will be tied up for long periods of time, and the risk of market fluctuations eating away at their returns increases parallel to maturity. When the economy is growing, and investor confidence is high, the curve tends to slope upward more sharply, as long-term investments are made, and long-term projects are begun. Firms issue long-term bonds to finance projects that will take place over many years, or even decades, and the increased supply of long-term bonds pushes down the price and pushes yields up.
When a recession is looming, the yield curve tends to “invert,” in that it flattens and then even becomes slightly downward sloping. This occurs in the following way. Demand for long-term bonds increases as investor confidence in the health of the economy slumps. The increased demand for long-term bonds drives down their yields. On the other side of the curve, short-term yields boom as issuers offer a higher return to entice investors to return to their bonds. Prices on short-term bonds will have fallen when investors flock to long-term instruments.
Below you’ll find the current state of the yield curve on US Treasuries:
As you can see, the relationship between the three and five-year as they relate to the two-year is negative already. The relationship between the two and the ten-year are fast approaching this juncture, as well.
This is all evidence that the longest recovery in modern American history may well be coming to an end. Most indicators continue to show a healthy, even booming economy, but economic indicators lag underlying fundamentals, and the high is often most potent just before the crash (as it was in 2008, in 2001, and in the late 1920s). Only time will tell if this time is different (it never is), but an inverted yield curve has foreshadowed the vast majority of the recessions over the past 60 years.
There is no need to invert market strategy and become a bear overnight, but we should be weary of the coming inversion of the yield curve, what it has foretold in the past, and what it portends for the future.