Is the Yield Curve Suggesting a Recession Is Looming?

The U.S. Treasury yield curve has received a lot of attention in recent months as the difference between short- and long-term yields has fallen. But why is this important?

The yield curve is a graphical representation of bond yields of similar credit quality across a range of maturities. A flattening curve, when shorter-term rates rise more quickly than longer-term rates (or fall more slowly), is often perceived as an indication that slower growth lies ahead. An inverted yield curve, where short-term rates are higher than long-term rates, has historically been an indicator that a recession is on the horizon.

But does a flattening curve mean an inverted curve and recession are likely in the near future? Not necessarily. We reviewed the last five economic cycles using the difference between 2- and 10-year Treasury yields to gauge the progression of a flattening yield curve and the resulting equity market impact. The results were mixed, as shown in the chart below, but in every case it showed that recession is likely not an immediate concern.

Additionally, one key difference between this cycle and others is the impact of global central banks. Monetary accommodation from the European Central Bank and Bank of Japan are keeping foreign rates low, which is in turn also putting downward pressure on U.S. rates, likely making the yield curve flatter than it would otherwise be. This could mean that the growth outlook for the U.S. economy is actually better than the yield curve would suggest, in line with the more positive views suggested by earnings growth, Purchasing Managers Indexes, and soft data indicators such as consumer confidence.

According to John Lynch, Chief Investment Strategist, “Yield curve steepness hit 0.5% for the first time in this cycle on January 4, 2018, but our analysis suggests investors shouldn’t be concerned just yet. Based on the past five economic cycles, the move from 0.5% yield curve steepness to a recession took a median of more than 2.5 years, and the S&P 500 Index moved higher each time, seeing a median cumulative price gain of 21.5%. The combination of historic patterns and the current environment of low rates overseas suggests the US yield curve could remain flatter than it otherwise would normally be at this point in the cycle.”

 

IMPORTANT DISCLOSURES

The economic forecasts set forth in the presentation may not develop as predicted.

The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual security.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond and bond mutual fund values and yields will decline as interest rates rise and bonds are subject to availability and change in price.

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