Joseph G. Mowrer III, The Daily Record Newswire
The yield curve is a line that plots the relationship between bond yields across various maturities. But it is more than just a line. Since it does not represent the opinion of just one or a small group of economists, but rather the aggregate consensus of the whole marketplace, it can be a powerful predictor of future economic activity, interest rates and inflation.
The slope, or steepness of the yield curve, is determined by the differences between short-term and long-term interest rates. The yield curve steepens when long bond yields increase at a faster pace than short bond yields, and vice versa. Normally, the yield curve is positively sloping, meaning the longer maturity bonds have a higher yield than shorter maturity bonds.
As the market’s view of the future changes, so does the slope of the yield curve. A steepening yield curve (long rates increase faster than short rates) indicates the potential for stronger economic growth and higher inflation expectations. This shape would indicate that investors demand a premium for locking up their capital in fixed income for a longer period of time. Conversely, a flattening yield curve indicates slower economic growth and reduced inflation expectations. Investors in this environment are more willing to buy long term bonds as they feel there is less risk in doing so.
And lastly, a negatively sloped-yield curve (or inverted) is almost a sure bet that a recession is coming. This rare shape of the yield curve indicates that the future economic conditions look so dire that investors are willing to pay a premium to lock in longer maturity bonds as there is no safer alternative.
Historically, changes to the slope of the yield curve have been a fairly reliable indicator of our economic future. Below is a chart showing yield data for the major inflection points since 1990. In each of these cases, when the slope was steepest, the stock market (as measured by the S&P 500) followed with strong positive performance, and when the slope was flattest (or inverted), the stock market went through a subsequent period of decline.
Today, at 2.29 percent, the yield curve is steep relative to its average. And of particular interest, it has steepened at an alarmingly fast past. It was only 1 year ago in June 2012 that a 10-Year Treasury Bond has a yield of less than 1.5 percent, and the spread to a 2-year Treasury bond was around 1.2 percent. This is a dramatic and rapid increase in slope, and, if the yield curve is once again correct, it is signaling a period of strong economic growth and positive future stock market performance.
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Joseph G. Mowrer III is a senior tax-sensitive fixed income analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
