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May 19, 2018

The Yield Curve Is Getting Flatter, What Does That Mean to You?

By Charles Rotblut, AAII

The stock market endured a mini tantrum on Tuesday in response to a rise in bond yields. The Wall Street Journal described the 10-year Treasury note’s yield as experiencing its largest one-day increase since March 2017. The rise was big enough to cause the benchmark note to end the day with its highest yield in nearly seven years. Even before rising further yesterday and today, the yield hit a level not seen since the summer of 2011.

In addition to daily moves in the 10-year Treasury note, many financial market observers are eyeing the yield curve. The yield curve is a plot of the yields for Treasury securities of varying maturity. Under completely normal conditions, the yield curve would be rising upward with lower yields for shorter-term securities and higher yields for longer-term securities. This makes sense because the longer an investor has to wait to get their money back, the more compensation they are going to demand. Inflation isn’t much of a risk over 90 days, but it is a risk over periods of, say, five, 10 or 30 years.

Typically, this is how bond market participants think. They’re comfortable with getting lower interest rates on bills and notes with shorter periods to maturity and demand higher interest rates on bonds with longer periods to maturity. Occasionally, sentiment changes and the bond curve either flattens or inverts. When there is even a perception of this phenomenon occurring, heads turn.

Since the mid-1970s, every economic recession in the U.S. was preceded by an inverted yield curve, an observation made by Michael W. Klein on the EconoFact website. Specifically, recessions followed periods when the 10-year Treasury note’s yield fell below that of the two-year note’s yield. In such scenarios, you could get a higher interest rate for locking your money up for just two years as opposed to 10 years.

Such a situation could occur if traders expected inflation to weaken in the future. Less economic growth or an outright recession would alleviate upward pressure on prices and potentially increase the risk of deflation. The actions of the Federal Reserve can also have an effect, as Klein notes. If the Federal Reserve raises short-term rates, yields could rise more on the short-end of the curve than they do on the long-end of the curve. This would happen if traders expect the Fed’s actions to be temporary or very gradual in scope, the latter of which has so far currently been the case.

Presently, the difference between the two-year note and the 10-year note has narrowed. This is apparent on the chart above, which provides a year-over-year comparison. Twelve months ago, you could get nearly a full percentage point (100 basis points) more in yield by buying a 10-year note instead of a two-year note (1.26% for the two-year note versus 2.22% for the 10-year note). As of yesterday, the differential has been cut almost in half (2.58% versus 3.09%). Notice how much more the yield on the two-year note has increased, 132 basis points, relative to the 10-year note, whose yield has risen by 87 basis points.

Not specifically highlighted on the chart, but still visible, is the flattening at the long-end of the curve. It’s most apparent when looking at the five-year note in comparison to the 30-year bond. (The five-year note is two dots to the right of the two-year note; the 30-year bond is the last dot on the right side.) Twelve months ago, the yield difference between the two securities was 115 basis points (1.76% versus 2.91%). As of yesterday, the differential narrowed to 27 basis points (2.94% versus 3.21%). You can see other comparisons on the Treasury Department’s website. (Note: The website requires a Flash-enabled browser.)

It’s too early to worry about the next recession occurring. Even a casual observer can surmise that the Federal Reserve’s actions are having an impact on the bond market. Corporate revenues and earnings were strong during the first quarter. The new tax law is boosting corporate profits and giving many taxpayers extra cash. Plus, as Klein points out, there is no consistent pattern of how quickly the start of a recession follows the inversion of the yield curve. Rather, for the recessions that preceded the 2008 financial crisis, the length of time between the inversion and the start of the recession has varied between 10 and 18 months.

The curve shows that the rewards for going out to the very long end of the curve aren’t high enough to justify the term risk. You are not getting enough extra yield to compensate you for the extra time. At the short end, the curve is telling you to go shopping for interest rates if you are a saver. Significantly higher rates on savings accounts and certificates of deposits (CDs) can be attainable if you’re willing to bank online. For instance, Discover—with whom AAII has an affinity program that I personally use—is currently offering AAII members 1.60% interest on their savings accounts.

The Week Ahead 

Many more retailers will report during what should be the last busy week of first-quarter earnings season. In total, we should see announcements from 24 S&P 500 companies, including TJX Companies Inc. (TJX) and Intuit Inc. (INTU) on Tuesday; Target Corp. (TGT) and Lowe’s Companies Inc. (LOW) on Wednesday; and Medtronic PLC (MDT) and Ross Stores Inc. (ROST) on Thursday.

The week’s first economic reports will be the May flash composite Purchasing Managers’ Index (PMI), April new home sales and the minutes from the May Federal Open Market Committee (FOMC) meeting, all of which will be released on Wednesday. April existing home sales will be released on Thursday. Friday will feature the University of Michigan’s final May consumer sentiment survey and April durable goods orders.

Six Federal Reserve officials will make public appearances: Atlanta president Raphael Bostic, Philadelphia president Patrick Harker and Minneapolis president Neel Kashkari on Monday; New York president William Dudley and Philadelphia president Patrick Harker on Thursday; and Chicago president Charles Evans, Dallas president Robert Kaplan and Atlanta president Raphael Bostic on Friday.

The Treasury Department will auction $33 billion of two-year notes on Tuesday, $16 billion of two-year floating rate notes (FRN) and $36 billion of five-year notes on Wednesday and $30 billion of seven-year notes on Thursday.

Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)    

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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