The Yield Curve Is Screaming — Is Anyone Listening?

By Angela Koch, CEO of U.S. Money Reserve

Suddenly everyone is talking about the yield curve: Barron’s, Bloomberg, The Wall Street Journal. It turns out that studying the arc of government bond yields across a range of maturity periods provides insight into the underlying health of the economy.

Currently the difference between the yields on two-year and ten-year Treasury bonds has reached the narrowest point since before the financial crisis of 2007–2009. So why should we care?

First of all, when we discuss “yields,” we’re really referring to the dividends or the anticipated rate of return on a given investment. A “yield curve” plots the yield of investment instruments of varying maturities. The Treasury yield curve demonstrates the relationship between short-term U.S. Treasury bills and long-term Treasury notes and bonds.

Treasury yields operate under the general premise that the longer one keeps a government note or bond, the greater the rate of return. Therefore, a normal yield curve typically charts lower for Treasury bonds with the shortest maturity dates and higher for those with the longest. In other words, holders of the latter are compensated at a higher rate for having their money tied up for a longer period of time.

For the majority of the nearly 80 years since the Great Depression, a normal, upwardly sloping yield curve has been a good indication that the economy is expanding.

Yield curves can fluctuate, however. Short-term Treasury notes track the federal funds rate, and economic angst can send their value tumbling if investors perceive that the economy is slowing and that Fed action is required. This sends investors scrambling to buy long-term bonds, pushing those yields lower simply by virtue of supply and demand.

If the yield on short-term bonds rises higher than the yield on long-term bonds, it results in an “inversion.” A yield curve inversion is an economic watershed that cannot be overlooked.

Nearly every historic economic cycle in which long-term Treasury yields were lower than short-term yields has been a precursor to a recession. Last week John Williams, President of the Federal Reserve Bank in San Francisco, acknowledged that an inverted yield curve is a “very clear symbol that the economy is about to go into recession.”

In another report, Ed Yardeni, President of Yardeni Research, stated, “History shows that inverted yield curves have tended to trigger financial crises, which have caused credit crunches and recessions.”

While we are not currently experiencing an inversion, the yield curve is steadily narrowing, and investors are getting nervous. The flattening of the curve could be a crucial economic warning. If the gap continues to close at its current rate, it could be on pace to invert sometime between the end of this year and early 2019.

Each of the last five recessions was preceded by an inverted yield curve. Make no mistake — this financial indicator is desperately trying to get our attention. And now would be a very good time to take note and take action to protect our assets.