Does A Flattening Yield Curve Mean Recession Is Looming?

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by: Aubrey Basdeo

A flattening yield curve has been a reliable leading indicator of past economic slowdowns, but this time around maybe different.

What does a flattening yield curve mean these days? Perhaps not what it used to.

No doubt, the slope of the yield curve, as measured by the spread between two- and 10-year government bonds, has been flattening since 2014 in both Canada and the United States, and the trend has recently intensified: as we headed into December, the curve sat at its flattest level since the Great Recession.

Fixed Income 101 tells us that this foreshadows slowing economic growth. More worrisome, when the two-year/10-year spread hits zero, or less (yield curve inversion), that's generally considered a slam-dunk for impending recession.

So says the textbook. But we acknowledge that some unusual factors are driving the curve flatter in the post-recession era, and they might not signal slowdown or impending recession:

  • Lower potential growth in this cycle, in which case the curve should be flatter than in previous expansionary phases.
  • Inflation expectations are low, justifying lower risk premia for long bonds.
  • Canadian and U.S. central banks are in a hiking cycle, raising short-term rates, which adds to the flattening.
  • Monetary policymakers in Japan and Europe are still engaged in quantitative easing, which is suppressing long yields and driving Japanese and Euro bond investors elsewhere. That's suppressing long yields in North America.
  • The trend toward pension plan de-risking and insurance companies hedging their long-date liabilities has created a huge demand for duration - which, again, is flattening the curve.

And yet, against these perhaps-unique factors, the yield curve may still be foreshadowing a slowdown. After all, the era of easy money may be coming to a close. That has negative implications for growth, for both structural and historical reasons.

So while we can see the extenuating circumstances creating a flatter yield curve, we're not quite ready to declare that it's different this time. In fact, we believe that the curve is telling investors to tread carefully and be cautious, in particular, when it comes to risk asset allocation.

This post originally appeared on the BlackRock Blog.

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