Troubling Signs in the Bond Market: Yield Curves Going Flat

There are some troubling signs for the economy in the bond market. Yield curves are going flat.

On Wednesday, the yield curve from 5 to 30 year bonds flattened to as little as 29 basis points. That represents the narrowest spread since 2007. The yield curve between 2-year and 10-year Treasuries also narrowed, touching 41 basis points, also the smallest gap since before the financial crisis. Investors extending to 10 years from 7 pick up just 4.3 basis points, less than a quarter of what they got a year ago, according to Bloomberg.

So, what does this mean?

Narrowing yield curves generally signal increasing skepticism about the long-term outlook for economic growth and inflation.

In general, investors demand a higher rate of return for locking their money up in long-term bonds and yield curves normally slope upward. The rate of return on a 2-year bond will typically be less than the return on a 10-year bond.

During economic expansions, inflation expectations tend to rise. As a result, investors demand even higher yields for long-term bonds to offset this effect. A sharply upward-sloping yield curve generally means investors have optimistic expectations for the future.

But during recessions, inflation tends to fall. That puts downward pressure on long-term yields. The difference between long-term and short-term yields flattens and eventually inverts. As Bloomberg noted, “An inverted yield curve, by contrast, has been a reliable indicator of impending economic slumps, like the one that started about 10 years ago. In particular, the spread between three-month bills and 10-year Treasuries has inverted before each of the past seven recessions.”

Future New York Fed president John Williams said this week that a truly inverted yield curve “is a powerful signal of recessions” that historically has occurred “when the Fed is in a tightening cycle, and markets lose confidence in the economic outlook.”

In a recent report, Citigroup analysts led by Jabaz Mathai said investors should take the possibility of an inverted yield curve very seriously.

The historical relationship between the curve and implied recession probabilities is highly non-linear: implied probabilities grow very fast when the curve moves into inverted territory.”

The flattening yield curve poses a dilemma for Federal Reserve Chair Jerome Powell. Stubbornly low long-term yields could eventually force the Fed to slow down its monetary tightening policy.

TIAA Investments portfolio manager Katherine Renfrew told Bloomberg the Fed will have to be very sensitive to the shape of the yield curve.

If we get to the point where inversion might begin to happen, the Fed may put the brakes on further dialing back monetary stimulus.”

The Bloomberg report said something will have to give, “at least, if the Fed wants to keep investors from speculating that a recession is approaching.”

It took only about six months for the curve from 5 to 30 years to flatten from around 30 basis points to zero in 2005-2006. The curve from the 2-year to the 10-year narrowed from 40 to zero in roughly the same amount of time. If that trend repeats, the curve will be completely flat by the end of this year.

It probably won’t shock you to know that the Fed has a hand in all of this. It is intentionally pushing up short-term rates as part of its tightening policy. That naturally flattens the spread. But there is a bigger picture. Markets don’t like having their easy-money punch bowls taken away. When you have a boom driven by loose monetary policy, and the policy begins to tighten, bubbles can start to burst. As a result, things can quickly go bust. So, the Fed’s quest to “normalize” rates not only naturally flattens the yield curve, it could crash the bubble economy. This could explain the correlation between Fed monetary tightening, flattening yield curves and the onset of recessions.

So, what will the Fed do? It obviously wants to continue raising rates. After all, everything in the economy is great! But that will almost certainly continue flattening the yield curve. As Bloomberg put it, “Investors would likely take that as an ominous portent. ” If the curve inverts, I would look for the Fed to slow down or even reverse its rate hikes.

The mainstream keeps telling us everything is great, but as we said in an article earlier this month, optimism can’t trump economic reality. Tightening yield curves are yet another sign everything isn’t as rosy as the pundits want you to think.

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