If you’re wondering what a yield curve is and why there’s so much fretting in the U.S. over it flattening -- and what that even means -- you’re not alone. Last month, Google searches for "yield curve flattening” shot up to their highest level in over a decade. Here’s what the fuss is about.
1. What’s a yield curve?
It’s a way to show the difference in the compensation investors are getting for choosing to buy shorter- or longer-term debt. Most of the time, they demand more for locking away their money for longer periods, with the greater uncertainty that brings. So yield curves usually slope upward.
2. What’s a flat yield curve?
A yield curve goes flat when the premium, or spread, for longer-term bonds drops to zero -- when, in other words, the rate on 30-year bonds is no different than the rate on five-year bonds. If the spread turns negative, the curve is considered “inverted.”
3. Why does it matter?
The yield curve has historically reflected the market’s sense of the economy, particularly about inflation. Investors who think inflation will increase will demand higher yields to offset its effect. Since inflation usually comes from strong economic growth, a sharply upward-sloping yield curve generally means that investors have rosy expectations. 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.
4. What’s been happening with U.S. yield curves?
They’ve grown much flatter this year, especially in the last few weeks. The spread between two-year and 10-year notes is 56 basis points, down from 125. (A basis point is one one-hundredth of a percentage point.) The spread between five-year and 30-year bonds, which was 114 basis points at the start of the year, is now 63.
5. Why is that?
There are lots of theories and no shortage of factors. On one hand, the Federal Reserve is steadily increasing short-term rates in response to the economy growing at a moderately strong pace. But in the U.S., as in most other developed countries, inflation is running below expectations despite the stronger growth. That’s kept a lid on long-term yields, which have hardly budged. Two other possible reasons: Pension funds and insurers have developed an insatiable demand for long-term, high-quality bonds, and the European Central Bank and Bank of Japan continue to make large long-term bond purchases. Both of those developments drive down those yields.
6. What does this mean for the Fed?
That’s the big question. A majority of Fed policy makers want to keep raising rates to balance growth and to create room to maneuver in case of an economic downturn. But the Fed has also been notably shy about upsetting markets in the wake of the financial crisis. So will it continue to flatten the yield curve down by raising short-term rates? Investors would likely take that as an ominous portent. Cleveland Fed President Loretta Mester recently shrugged off market worries, while St. Louis Fed President James Bullard has said policy makers should pay attention to the flattening curve because it’s a bearish signal for the economy. If there’s enough consternation, that could throw off the Fed’s current plans to hike rates three times in 2018.
7. What do experts think will happen?
A growing chorus of fixed-income strategists on Wall Street expect yield spreads to keep shrinking in the years ahead. A handful expect the curve to flatten to zero or even invert sometime in 2018; others see that as more likely in 2019. But as long as the Fed is raising short rates, predictions of a steeper curve will remain in the minority.
The Reference Shelf
- Wall Street is starting to plan for an inverted yield curve in 2018.
- A Bloomberg News overview of the factors that might be flattening the curve.
- Europe prepares for its curve to flatten as well, Ben Emons writes in Bloomberg Prophets.
- A Federal Reserve Bank of San Francisco paper on the recent squeeze on the yield curve.
- Frequently asked questions on the yield curve from the Federal Reserve Bank of New York.