Market Minute - August 14, 2018
by Scott Rosenquist, CFA
Yield Curve Implications
The yield curve is a widely followed measure of the bond market that shows the yields available for bonds of the same credit quality and varying maturity dates. The most common is the U.S. Treasury yield curve, a favorite among investors who monitor it for clues on the direction of the economy.
The shape of the yield curve can indicate potential changes in the economy. A normal yield curve is upward sloping with short-term bonds yielding less than longer-term bonds. This shape is typically associated with positive economic growth. It reflects that the longer an investor commits funds, the more yield they demand for taking on that risk. The opposite of this scenario would be an inverted yield curve, where short-term bonds yield more than longer term bonds. This is a rare occurrence and historically forecasts recessions.
This leads us to where the yield curve stands today (as of 7/31/18). As the chart from JPMorgan shows, the yield curve has flattened quite a bit over the years as the U.S. recovered from the financial crisis
The chart shows the significant rise in the front of the curve which the Federal Reserve influences. This reflects the Federal Reserve raising the federal funds rate several times as the economy recovered. The long end of the curve is less influenced by the Fed and reflects more about the economy in terms of growth and inflation expectations. Market participants have been asking themselves if the yield curve will invert and what the ramifications may be given the history of this indicator.
While an inverted yield curve has been a reliable indicator of impending recessions, past cycles have seen varying time periods between inversion and recession ranging from months to a year or more. It is not uncommon to see equities continue to move higher during this timeframe. It is also important to acknowledge that some external factors may be affecting the longer-term bonds within the curve. One of the factors is the demand from international markets, such as Europe and Japan, which is are grappling with historically low yields in their domestic markets. These foreign investors see U.S. yields as more attractive than what they can get locally, increasing demand. This demand can prevent the yields on the longer-term bonds from rising, contributing to the flattening and potential inversion of the yield curve. Given this dynamic, the broad economic data continues to show strength through the employment numbers, GDP growth and reported earnings.
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