Big news this week as the U.S. yield curve has been flattening rapidly. Why should you care?
Here Bloomberg takes a look at the spread (or difference in interest rates) between 3 month treasury bills and 10 year treasury notes. Notice how inverted spreads (where short term treasuries yield more than long term treasuries) have often been a sign of an imminent recession:
The chart above is from an article in Bloomberg, found here.
When the yield curve is “flattening” short term treasury yields are getting closer to long term treasury yields. When the yield curve is “steepening” the yield for longer term treasuries are increasing compared to shorter term treasuries.
For example, if the 2 year treasury is yielding 2% and the 10 year treasury is yielding 3%, the “2-10 spread” is 1%.
When the yield curve “inverts”, short term treasuries yield more than long term treasuries. For example, a 2 year treasury may yield 2.5% and a 10 year treasury may yield 2.3%, for a 2-10 spread of -0.2%.
Why So Much Focus on the Yield Curve?
Investors focus on the yield curve for a couple of reasons:
First, let’s think about how the price of treasuries and their yields would change based on investor sentiment.
(For a more in-depth look at the relationship between a bond’s price and its yield, see our article here: The Relationship Between a Bond’s Price and its Yield)
Long term rates are largely indications of investor expectations of growth and inflation. When choosing an investment for a 5, 10, or even 30 year time horizon, you want to be sure you are receiving a high enough interest rate to account for future inflation. If you believed inflation 10 years from now would be 5%, would you lend money for 10 years at 2%? Probably not… If long term rates are low, investors are willing to lock up capital for long periods of time for low returns, that is telling of low confidence for future growth.
Or, strong demand from long term bonds can be a sign that investors are fearful of the future, and willing to accept very low, or even negative returns in the future in exchange for safety. If you believe that stock prices will drop 20%, a 2% return, even though it is low, sounds a lot better than -20%!
Either way, a flattening yield curve is a sign of lower future expectations for growth and/or returns.
Second, a lot of financial companies’ earnings are based on the steepness of the yield curve. Banks lend “long” and borrow “short”, meaning they pay short term rates to borrow money, and charge the longer term rates to those getting a loan. When short term yields rise and long term yields fall, banks make less money on their loans. You can look at any bank’s financial report for a “Net Interest Margin”, this details how much money they are able to make on their loans. As the yield curve has flattened, we are likely to see bank interest margins down from the previous year.
This means lower bank earnings, and bank stock prices are likely to follow.
Chart(s) of the Week: Yield Spreads Around the World
The yield spread for the U.S. is one story, but I was curious if other countries are seeing the same thing.
Have yield spreads for other countries been narrowing, like the U.S.?
Here we look at the 2-10 spread (That is, the difference in yields from the 10 year treasury note and the 2 year treasury bond) today compared to the spread 1 year ago:
and here the 5-30 spread (The difference between the yields of the 30 year bond and the 5 year note) today compared to 1 year ago:
And lastly, I wanted to chart these countries’ stock market returns over the year as well:
First, notice that although Brazil’s yield curve was inverted last year, Brazil stocks have been doing fairly well, so don’t bet the house that if the yield curve inverts we will get a recession.
Stock markets around the world have been trading in parallel. As I write this, Israel is the only country whose stock index is down this year. (See for yourself on the Wall Street Journal’s International Stock page)
But worldwide treasury markets are not all trading the same. Brazil, India, Japan, and Russia are seeing their yield curve steepen over the last year. While the U.S., U.K., and China have seen their yield curves flatten.
Perhaps this is a sign that we may see stock performance begin to diverge as well.
Treasury Bond, Bill, and Note – What’s the difference? See our article here: The Difference Between Treasury Bills, Notes, and Bonds
Need to diversify your investments into other countries (whose yield curves are steepening?): Fund Spotlight Series: Emerging Market ETFs