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One of the more important indicators to follow for a sense of where the global economy and financial markets are headed is the yield curve. It’s defined as the difference between yields on ten-year and two-year U.S. government bonds.

There are times when the two-year yield exceeds the ten-year yield – a condition known as the “inverted” yield curve. It doesn’t happen often but when it does, it historically has foreshadowed recession.

“Each of the past seven recessions was preceded by a brief period when the yield curve was inverted and there has only been one false signal,” says Financial Times of London columnist, John Authers.

The yield curve typically inverts when the Federal Reserve is trying to cool off a fast-growing economy by engineering an increase in short-term interest rates. Meanwhile, long-term rates stabilize, or even fall, as investors worry less about inflation and buy bonds to lock in rates.

When ten-year yields are above two-year yields, the curve is said to have a positive slope. Historically, the more the ten-year yield exceeds the two-year yield – i.e. the greater the positive slope — the more likely the economy and financial markets are headed higher.

The Federal Reserve will be trying to stimulate the economy with lower short-term rates while longer-term rates may be edging up because investors are buying fewer bonds due to concerns about inflation and rising rates (don’t want to lock in at low rates if higher rates are expected down the road).

Right now, the yield curve is very steep — at record levels, in fact. Last week, the ten-year Treasury yield stood above two-year Treasury yields by 2.94 percentage points, a spread never seen before since data collection began in 1976.

“Its previous peaks were at about 2.5 percentage points in October 2003, when a brief bull market in equities was gathering pace, and October 1992, when years of expansion for both markets and the economy lay ahead,” notes Mr. Authers.

Why such a wide spread? On the short end, the Federal Reserve is holding rates close to zero to stimulate the economy. On the long end, the U.S. government is dumping a huge supply of bonds onto the market to finance a giant deficit; it needs to offer higher yields to get investors to accept so much supply, especially as inflation fears rise.

Going by the past record, the record spread between ten- and two-year yields would seem to suggest recent jitters over the economic recovery and stock market uptrend should prove unfounded. Indeed, the economy could surprise on the upside given how steep the positive slope is in the curve.

Record spreads should dramatically increase bank profit margins. The banks can pay low interest rates to depositors and lend at much higher rates on mortgage and business loans. In short, by giving banks a substantial incentive to make loans, the positive yield curve provides the basis for economic expansion.

Yet false signals cannot be ruled out. In particular, U.S. bank credit is still contracting – also at record levels. Loans from commercial U.S. banks are down 10 per cent over the past year. Previously, the most bank credit ever fell during a 12-month period was 2 per cent in the early 1990s (since record keeping began in the mid-1970s).

Furthermore, as Gluskin Sheff economist David Rosenberg notes, bank credit has fallen another $100 billion (U.S.) since 2010 began. That is an accelerated rate of decline, amounting to 16 per cent on an annualized basis. Offsetting this contraction somewhat is a pick-up in borrowing through the corporate bond and commercial paper markets.

The uptrend in debt over previous U.S. business cycles seems to have left behind an extended period of deleveraging. Some think it means another dip into recession. Others, however, believe a full recovery is just a matter of time: an even steeper and more prolonged positive slope may be required, but eventually the yield curve will be right.

Source: Deciphering the Record Extremes of the Yield Curve