Reading Treasury Yield Curves

October 08, 2018

[This article appears in our November 2018 issue of ETF Report.]

There’s a lot of folly in trying to predict markets. Still, everyone is trying to predict the next recession.

One of the commonly used metrics in that exercise is the steepness of the U.S. Treasury yield curve. Some measure that as the spread between two-year and 10-year Treasury yields, some look at three-month and 10-year. Either way, the curve has been flat this year—and flattening—to a point where some now are looking for an inversion in the yield curve in the near future.

This rarest of curves, where short-term bonds yield more than long-term debt, has historically been associated with a recession. So, is that what the yield curve is currently telling us, that a recession may be coming?

Good question. Maybe.

Year-to-date (as of early October), the yield on the two-year has gone up 0.98% to about 2.87%. Meanwhile, the 10-year has risen about 0.79% to 3.19%. In other words, both yields have been on the rise in 2018, but the shorter end of the curve has been going up faster. The spread between the two yields has significantly flattened, dropping by more than half so far this year.

 

1-Year Look at Treasury Yields

 

Behind Yield Moves

The Federal Reserve and the fed funds rate typically drive the short end of the curve. The Fed has already raised rates eight times in this cycle, three times this year alone. And more rate hikes are expected ahead.

The long end of the curve, however, is driven more by economic growth and inflation. Going forward, economic growth is generally expected to be more “lackluster,” which, combined with expectations of only modest inflation, could lead to lower 10-year yields, BlackRock’s Head of Americas Systematic Fixed Income Strategy Matt Tucker says.

A relatively aggressive Fed raising rates in an environment of modest growth and inflation could push up short-term yields even further, he notes, and so the flattening—and potential inversion—goes on.

“There's a lot of debate about what leads what; does a recession lead to the inverted yield curve, or does the inverted yield cause the recession?” Tucker said. “The general narrative is that, if the Fed Open Market Committee is aggressive at raising short-term interest rates, this will slow down economic growth, and if they go too far, they can actually trigger a recession.”

The last inverted yield curve happened at very end of 2016, prior to the last crisis. Before that, it was at the end of 2000, before the tech bubble burst. These are still-fresh examples of the correlation between an inverted curve and market contraction.

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