Flattening Yield Curve: Should I Be Worried?

July 26, 2018

Flattening Yield Curve: Prognosticator of Doom?

If you read or watch the news, you have probably heard several prognosticators predict that the next recession is looming, and to head for the hills. Recently doom predictors have been focused on the flattening yield curve. It’s true a flat yield curve has been present in all 7 of the US recessions since the 1960’s. However, what’s also true is the yield curve has flattened in the past without a recession.

What is the yield curve?

The yield curve is the graphical representation of the different yields from different maturities of bonds. Generally, people refer to the US Treasury securities when they refer to the yield curve.

Below is the yield curve as of July 17, 2018 (green), as well as the yield curve from July 17, 2017 (blue) and July 17, 2016 (red).

As illustrated above, generally the longer the maturity on a bond (the further right you go on the above graph), the more yield you get. However, when the yield curve “flattens,” the additional yield you receive for holding longer term bonds diminishes. As you can see, over the last 2 years, the yield curve has flattened considerably.

As mentioned above, flat yield curves have come and gone without a recession. However, it is also possible for the yield curve to “invert.” An “inverted” yield curve is when longer dated bonds yield less than shorter dated securities. This is both counterintuitive and rare. Additionally, the yield curve has “inverted” prior to each of the last 7 recessions in the US. The below graph shows the spread, or difference, between the yield on 10-year Treasury Notes versus 2-year Treasury Notes. When the chart dips below zero, that is considered an “inversion,” and indicates times when investors are getting more yield on shorter term bonds than longer term bonds – a potential warning sign.

If yield curve inversion is so predictive, and we have a flat yield curve today, should we be heading for the exit? Probably not. As mentioned above, a merely flat yield curve does not always indicate an imminent recession. Additionally, even if the yield curve were to invert, there would not be an instantaneous recession. Since 1980, a yield curve inversion has preceded a recession by an average of nearly one and a half years. See below:

Goldman Sachs research indicates that in the year prior to recessions, average equity returns are approximately 8% (Source: GSAM, NBER, Bloomberg). In the 2 years prior to a recession, returns are nearly 21%. This is a lot of return to potentially give up in the face of a recession that is not likely right around the corner.

Additionally, it warrants mentioning that a number of other indicators point to a still healthy economy. Corporate earnings are strong, unemployment is low, and consumer sentiment remains high.

Conclusion: What Should I Do?

It is tempting to succumb to headlines predicting imminent doom. The better path is to stay patient and disciplined with a balanced portfolio. If you were to pull out of the market every time the yield curve inverted, you would miss out on returns in excess of 8% on average.