The Yield Curve Is Flattening, Potentially Signaling a Recession
WASHINGTON, DC – July 24, 2018
Prediction is a thankless task, especially in financial markets. However, being able to determine General trends and understand their consequences is a useful skill. In this article we are going to define what a yield curve is, why it is so important, and why another U.S. recession may be rapidly approaching.
In short, the yield curve is a line graph showing the yield of the same financial instruments with different maturity dates. The most frequently reported yield curves compare three-months, two-years, five-years and 30-years of U.S. Treasury debt. Most of the time, experts that are talking about “the yield curve” are talking about the difference between interest rates on two-year and ten-year U.S. Treasury bonds. It is considered normal when rates on short instruments (two-year Treasury bond ) are less than those on long ones (10-year and more).
Here is the so-called yield curve of American treasuries. For example, if the yield on 2-year bonds is 2% per annum, 5-year 5% per annum, and 10-year 10% per annum, it means that market participants believe in future growth, and the chart will have the following form:
If the yields of all securities are approximately the same, it will take the form of a flat curve, and if the yields of shorter securities are higher, the chart will have an inverted form:
This happens rarely, and is usually a harbinger of the start of a recession and risk avoidance.
We have seen the yield curve invert seven times since the 1960s, and in each of those seven instances an economic recession in the United States has followed. Will this time be any different? Today, the yield curve is the flattest that it has been in 11 years, and many analysts believe that we will see an inversion before the end of 2018. If an inversion does take place, experts will be all over the mainstream media warning about “an imminent recession”. Unfortunately, most Americans don’t understand these things, and when they hear terms like “yield curve” they tend to quickly tune out. However, the life of every American depends on what is happening in the markets. It's not a metaphor.
Now the US economy is at an interesting point: the dividend yield of shares is almost level with the yields of government bonds.
Changes in the curve matter because they affect bank lending, which impacts almost everything. A USA Today article recently explained how banks borrow at short-term rates and lend that money out at long-term rates…
Banks borrow at short-term rates, lend long term and profit from the difference. So the gap between long and short rates predicts future loan profitability. The bigger the gap, the more eager banks are to lend. The yield curve is a great predictive proxy for future lending.
Lending matters because loans allow for economically expansive activities. Sally deposits $10,000 at Community Banks-R-Us, which can keep $1,000 in reserve and lend out $9,000 to Jim’s Widgets. Jim uses that to grow his business. Hence lending can fuel growth. So, steeper yield curves spur economic activity. Flatter curves render less.
When banks cut back on lending, that has the effect of “choking off” the economy, and that usually leads to an economic contraction.
The yield curve inverted prior to the recession of 2008, and lending started to get a lot tighter. The resulting recession was a surprise to many Americans, but it should not have been. It was simply the logical conclusion of basic economic forces at work.
Interestingly, yield curves are about to “invert” in Japan, Germany and China too.
But some experts insist that the decline in the market has stopped. The main indicator is 10-year treasuries. They were actively sold, but then the price rose sharply and is now at about the same level. This means that investors do not want to "scatter" the yield any longer — and in 10-year bonds it is almost 3% in US dollars. It is a lot, taking into account that the creditor is the US Federal reserve.
Inter-market analysis now shows significant shifts in the markets. The last two weeks timber and industrial metals — copper, nickel, lead, tin and etc. - have been falling significantly. Last week, oil began to decline. Raw material sales are a harbinger of global change. Maybe it’s not about the super cycle, but there is surely concern for a medium-term reversal .
We live in the era of global trade wars. It means that in the US stock market may be weak and need strong correction. In addition, almost all experts agree that 2018 is the year of increased volatility. The S&P500 index for the day may change by one percent in any direction. But most likely, the next year or two in this market will be an upward cycle.