A Flattening Yield Curve: What Does History Tell Us?
What is the shape of the yield curve telling us in 2018? As it continues to flatten, does it portend a coming recession?
Over the last year, the U.S. Treasury yield curve has become flatter. Much of this flattening is likely due to the Federal Reserve continuing to hike interest rates in 2018 after keeping the short-term rate at zero for several years after the Global Financial Crisis. Meanwhile, longer-maturity bonds are in demand among investors, as geopolitical tensions and worries about global trade have bid up longer-dated Treasuries, pushing longer yields down.
This flatter curve comes in spite of a relatively solid economic backdrop in the U.S., with recent corporate tax cuts fueling continued optimism about earnings and the economy. Therefore, it’s hard to know what this flat curve may mean.
The Changing Shape of the Yield Curve
The shape of the U.S. Treasury yield curve gives investors a sense of economic growth. Normally, in times of economic expansion, the yield curve slopes from low to high, with shorter-term yields staying low and longer rates rising. But when interest rates start to rise at the short end, investors can find it risky to keep money in longer-term bonds if they are expecting those long bond prices to fall in the future. So, instead of being upward sloping, the curve starts to “flatten.”
A relatively flat yield curve could be interpreted to mean that an economy is slowing, and headed toward recession. This is because when the yield curve flattens, investors may be expecting inflation to decrease or the Federal Reserve to increase short-term rates—both of which are signs that the economy may decelerate in the future.
A flattening yield curve could also become an inverted yield curve, which occurs when shorter-term bond yields are higher than yields of long-term bonds. An inverted yield curve has been a reliable predictor of recession in every instance since 1950.
What Do Previous Flat Yield Curves Show?
Below we highlight several significant times in recent history when the yield curve was flat, and the economic outcomes that followed.
The 1960s and 1970s: Inverted Curves and Recessions amid War and an Oil Shock
The curve was flat for much of the time between 1965 and 1970, with shifts between 3 percent and 6 percent. A mild recession started in 1970 with fiscal tightening (closing the budget deficit from the Vietnam War) and rising interest rates.
From 1972 to 1973, the curve went from flat to inverted, with the front end of the curve close to 9 percent and the 10-year yield around 7.5 percent. The oil crisis in 1973 caused the front end to fall to a little more than 5 percent by mid-1975, while the 10-year yield remained around 8 percent.
In 1978 and 1979, with the global oil shock after the Iranian Revolution, the curve flattened and then inverted once again, with a significant inversion by November 1979. A mild 6-month recession came in early 1980 though on its heels was another inverted yield curve. By December 1980, the 3-month bill was 17 percent and the 10-year yield was 13 percent. A meaningful, 18-month recession occurred from 1981 to 1982 in the wake of the 1979 energy crisis.
The 1990s and 2000s: Inverted Curves and Recessions with Tech Bubble and Global Financial Crisis
Flat curves in 1995, 2000, and 2007 each occurred at the tail end of monetary tightening environments. In 1995, the economic environment was one with relatively robust domestic growth but an unstable international outlook due to a currency crisis that was building momentum. The flat yield curve in 1995 ended in a so-called “soft landing” when, after the Fed’s pace and scale of tightening negatively surprised markets, the Fed stopped hiking before triggering a recession.
The years 2000 and 2007 were followed by monetary policy easing. In 2000, the Fed resumed raising rates after the Tech Bubble. Subsequently, the yield curve inverted and a recession came in 2001. In the years leading up to 2007, Ben Bernanke’s Fed had been raising rates steadily, but Bernanke and other policymakers overestimated the strength of the housing market at that time. The curve inverted in August 2006, and a recession followed in late 2007.
Market dynamics in the wake of a flat yield curve have varied. Looking at recent years, after the 1995 flat yield curve, the following five years saw annualized U.S. equity returns of around 24 percent (as per the S&P 500) and fixed income returns around 6 percent (as per the Bloomberg Barclays U.S. Aggregate Index). However, following the flattening yield curve of 2000, the next five years saw annualized equity returns around -2 percent and fixed income returns around 8 percent. After June 2007, the next five years saw annualized equity returns around 0 percent and fixed income returns around 7 percent.
What Can Investors Expect in 2018?
The current economic environment feels more like 1995 than any other period we reviewed. In 1995, as it is today, the U.S. economy was relatively strong, without any obvious bubble lurking in the market, like technology in the late 1990s or housing in the mid-2000s. Unlike the 1970s, which were dominated by the oil crisis and ramifications of it, the energy complex is more diversified now. The economy in the 1960s was less service-oriented than the one we have currently, and it was driven by the buildup to the Vietnam War.
There are reasons for optimism here in 2018, including still-solid corporate earnings growth and little sign of high or runaway inflation worldwide. However, major differences between now and 1995 include the following:
- Today, developed market central bank balance sheets dwarf what they were in the mid-90s, meaning that the Fed will have less flexibility for further easing in the case of an economic downturn.
- The current starting point throughout the yield curve is around 350-400 bps lower than in 1995, offering very little cushion for missteps in policy and to combat disinflation, deflation, or a slowdown in productivity.
- In 1995, a productivity surge fueled economic growth, and instead of the loose fiscal policy that we have now, the government raised taxes twice and reduced its spending. By contrast, there is currently no major productivity surge, and fiscal policy is looser than before.
- The current geopolitical environment and protectionist policies make economic forecasting more difficult given the impact and evolution of global interlinkages on bottom--line growth.
With all of that said, a flatter yield curve does not automatically translate to impending recession. History has shown that flat yield curves exist against many economic backdrops. Further, the past isn’t always prologue, so what happens next with today’s flattening yield curve is unlikely to echo the past.
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