If you’re looking for a key to divining the direction of the economy and the financial markets during the coming year, start keeping an eye on the yield curve.
Since the yield curve has begun to flatten in recent months, some analysts have been noting its value when trying to anticipate market developments. The curve is plotted along the maturities of Treasury securities, from left to right ranging from three months to 30 years.
During normal times, the curve slopes upward. Longer rates are normally higher because as lenders agree to tie up their money for longer periods, the increasing risk factors justify a higher return.
The yield curve’s slope is related to economic health, and a rising curve is interpreted as reflecting good times. When the curve flattens, the spread between 30-year bonds and short-term bills grows smaller.
The yield curve’s spread over the past year, for instance, has narrowed by more than a percentage point as long rates have moved down while short rates moved up. Short rates have been primarily influenced by Federal Reserve monetary policy, and long rates have been reacting to lower inflationary expectations.
What does it mean when the curve flattens significantly? All else being equal, it reflects expectations of the slowing economic growth that usually results in lower inflation rates. While lower interest rates are usually good for stock prices, this is true only insofar as business is able to sustain improving profits in the face of a weakening economy.
The problems really begin, however, when a flattening yield curve evolves into an “inverted” yield curve. This happens when short rates climb higher than long rates.
An inverted curve is “one of the best indicators of coming recessions,” Conference Board senior economist Michael Boldin observed in a recent Investor’s Business Daily “Educating Investors” feature.
The last time the spread became inverted was prior to the recession that began in the summer of 1990. The negative spread then was a relatively modest 0.14 of a percentage point.
So lately, as the yield curve has flattened, the Fed’s critics point to this development as further proof that the economy requires stimulus rather than restraint as it slows.