Yield Curve Revisited

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by: Principal Financial Group

Robin Anderson, Ph.D., Senior Economist, Principal Global Investors

This week the flattening yield curve has investors worried. A key yield curve, the difference between the 2-year US Treasury rate and the 10-year US Treasury rate fell below 12 basis points at one point last week.

A yield curve flattens either because long-term rates are falling faster than short-term rates or because short-term rates are rising faster than long-term rates. Throughout this year, the yield curve has flattened because short-dated government bonds have been rising faster than long-term rates. The 10-year -2-year curve has flattened nearly 66 basis points from its year-to-date peak of about 78 basis points in early February. Compared to when the yield curve peaked, the 2-year government bond rate is up 67 basis points, but the 10-year rate is virtually unchanged. This makes sense; short-term rates picked up as the Fed hiked.

But since early October, the yield curve has been flattening because long-dated interest rates have been falling. Since October 5, the yield curve has flattened 22 basis points as the 10-year US Treasury rate has dropped around 37 basis points. The US 10-year has fallen with a decline in inflation expectations, the general risk-off tone in the markets, and fear of a global growth slowdown.

Markets got worried last week about the yield curve inverting, or short-dated interest rates moving above long-term interest rates. In fact, the yield spread between the 3-year and 5-year US Treasury rates went negative this week. An inverted yield curve is a key leading indicator of recession. The 10-year-2-year yield curve has inverted before every recession going back to 1980. The only time when the yield curve inverted when there was not a recession was 1998. The Federal Reserve will likely raise rates in December and another time early next year, so there is a risk that 10-year-2-year curve may invert sometime in 2019.

But, yield curve inversion does not mean recession is right around the corner. It's a long leading indicator. For example, most recently the 10-year-2-year curve went negative in December 2005, two years before the Great Recession happened. Prior to that, the 10-year-2-year inverted in February 2000, 14 months before recession started in April 2001.

The 10-year-2-year yield curve is not the only yield curve that leads recessions. Fed researchers show that the 10-year-3-month yield curve is the best recession predictor.1 Although, this curve has flattened a lot, it's still a long way from inverting, at nearly 50 basis points.

While the yield curves have been flattening most of this year, we still think the US economy is a long way from recession. Lots of other economic indicators are not signaling warning. Corporate profits are healthy, lending standards are easy, and industrial production is solid. Credit spreads have widened but are not to recessionary levels. We will continue to watch the yield curve, but it is one of many recessionary indicators that we follow.

1Baruer, Michael D. and Mertens, Thomas M. "Information in the Yield Curve about Future Recessions." Economic Letters, 27 August 2018.