The Yield Curve Is Sending a Message About the Fed

The “flattening yield curve” is back. The story took a breather when longer-term interest rates jumped during the first quarter. A more turbulent stock market, however, has driven investors back into bonds, putting the flatter yield curve in the news again and raising ominous concerns about a looming recession. Those worries are so far unfounded, but they indicate the Federal Reserve is further along in the tightening cycle than its latest projections suggest.

The difference between short- and long-term bond yields curve could remain relatively narrow for years, as it did in the late 1990s, while the economy continues to grow. As a result, the resumption of flattening, which has shrunk the difference between two- and 10-year Treasury note yields to less than half a percent for the first time since 2007, should not raise concerns of imminent recession. It is an inverted curve -- when short-term interest rates exceed long-term ones -- that has foreshadowed previous U.S. recessions. Recent research by San Francisco Fed economists found that the curve still has predictive power. That suggests we should not ignore any inversion.