What is a Yield Curve and Why Do We Care About It?
by Kelly Pedersen, CFP®
The yield curve is a graph plotting bonds differing in lengths of maturity and their corresponding interest rates. For example, the 2-year Treasury is yielding about 1.51% today, the 10-year treasury is about 1.56% and the 30-year at 2.31%. If you plot those three bonds on a graph you would get a “yield curve” that looks pretty flat, but the 10 year is greater than what you’d earn on the 2 year which is “normal.” If there is an event in time where the 10-year treasury would pay you less interest than a 2-year bond that plotted on a graph would be an “inverted yield curve.”
Historically, when the curve becomes inverted it has become a decent indicator that a recession will come to fruition within the next 6-18 months. The yield curve inverted slightly this week for a brief time and sent a reverberation through the markets that sounded the alarm for recession. Typically a market peaks about 6 months before a recession starts. While this has historically been a decent leading indicator for markets, we believe it may not be the most reliable indicator this time.
Short term interest rates are highly manipulated by the Federal Reserve Board, commonly known as “The Fed.” The last 10 years have seen an unprecedented involvement of the Fed manipulating interest rates to stimulate the economy which is quite unorthodox historically. That has a significant impact on bond markets as the Fed tries to unwind some of the monetary policies put in place over the past 10 years.
This is significant because the Fed really drives the shortest end of the yield curve to either stimulate (with lower rates) or pull back an overheating economy (by raising rates). The longer term bonds are a better indication of how the overall economy is doing for the longer term. So, when the Fed moves rates on the short end of the curve, it will change the “shape” of the curve to either be steep (stimulating), flat or inverted (slower growth).
The Fed lowered interest rates recently in efforts to keep the U.S. economy growth and inflation on the right paths. They acknowledged that the U.S. economy was still growing at a nice pace, although slower than historical averages, but that global issues around the world may start to have an impact on our economy. The conversation surrounding tariffs is not helping in this area. So it is also entirely possible that the economies around the world are affecting our yield curve in ways that were not baked into the equation in years past, as we are now in a much more global economy. When the U.S. lowered rates, then rates around the world lowered immediately thereafter. This still keeps our economy as one of the strongest in the world with steady domestic growth but financed by globally low interest rates.
For these reasons, we feel like the inverted yield curve may not be a perfect indicator of an impending recession. There are many other factors at play. A recession is likely inevitable but we feel like using the yield curve as a predictor may not have the historical relevance that it once had. When we do have our next recession, we believe it will be shallow and nothing like the Great Recession which is the one most engrained in many people’s memories. Instead, what we are seeing in the leading economic indicators is that the economy is slowing down from some sugar highs of the last ten years of stimulus but doesn’t directly indicate any sort of meaningful economic contraction.
We recommend that clients make strategic plans when markets are stable, taking profits and rebalancing. In times of turbulence, we recommend client not make knee-jerk decisions. Sometimes the market is overreacting to headlines that may or may not have real consequences on the market and the overall economy. If the recent market volatility was bothersome then that investment allocation may need to be massaged to better fit your needs before the next recession.