Interest Rates & the Economy

The yield curve is a graph with the rates of U.S. Treasury bonds plotted by maturity. The slope of the curve is the difference between short-dated bonds and long-dated bonds. Normally, it curves upward as investors demand higher yields to compensate for the risk of lending money over a longer period. The curve flattens, however, when the rates converge.

Investors pay attention to the yield curve to identify buying opportunities in the bond market and because it has a history of forecasting economic growth. A flat yield curve suggests that inflation and interest rates are expected to stay low for an extended period of time, signaling economic weakness. A steep curve indicates stronger growth ahead.

In the first week of December 2018, the difference between 10-year and two-year Treasury yields — an indicator that tends to be closely watched by investors — was the narrowest since 2007, though still positive. The flattening yield curve was partly to blame for a year-end spike in stock market volatility, because some economists and investors took it as a warning that the odds of an economic downturn were increasing.1

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Curve Confusion

Short-term Treasury yields are tied to the Fed’s interest rate policy, and the benchmark federal funds rate rose to a range between 2.25% and 2.5% in December 2018. Although the committee initially projected two more rate increases in 2019, projections released in March 2019 suggested the Fed might not resume raising rates until 2020.2

Yields at the long end of the curve are determined by supply and demand in the bond market and tend to reflect a broader range of factors, including the economic outlook and investor sentiment. Longer-term yields dropped over the last two months of 2018, partly due to investor concerns that tighter Fed policies could slow U.S. growth more than expected.3

Signs of a weakening global economy also appeared, while some export-driven economies were hit especially hard by trade disputes. China, the world’s second largest economy after the United States, is growing at its slowest rate in nearly a decade.4 In addition, uncertainty surrounding the United Kingdom’s exit from the European Union — or Brexit — has restrained growth in the region.5

Recession Worries

When short-term rates actually rise above long-term rates, the yield curve becomes inverted, signaling that a recession may be coming in about a year. In fact, the last seven U.S. recessions were preceded by an inverted yield curve. There have also been two notable false positives when recession did not follow an inversion.6

It’s possible that the bond market has been distorted by the central bank’s bond-buying program (quantitative easing), which was implemented to boost liquidity and help the economy recover from the Great Recession. If so, the yield curve might be a less-reliable leading indicator than it was in the past.

Only time will tell whether the yield curve’s gloomy economic forecast will come true, or whether the market-based indicator has been thrown off by monetary policy and/or global events. Either way, investors and economists (including policymakers at the Federal Reserve) would likely view a steeper yield curve as a step in the right direction.

U.S. Treasury securities are backed by the full faith and credit of the U.S. government as to the timely payment of principal and interest. The principal value of bonds fluctuates with market conditions. If not held to maturity, bonds could be worth more or less than the original amount paid.

 
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