Last week the global yield curve turned negative for the first time since the 2007 recession. This may not mean much to you if you are not a bond trader, so it is a good idea to look at why it is critically important.
A yield curve represents the difference between the interest rates for shorter-term government bonds (like two year Treasuries) and longer-term government bonds (such as 10 year notes). If an economy is healthy and growing, rates on such longer dated bonds will be greater than those for the shorter dated ones. It makes sense to reward investors who take on more risk for tying up their money longer.
In the last few weeks though, longer-term bonds have not been rising as you would expect if the economy was healthy. This indicates that smart money investors are worried about economic growth over the longer term.
Meanwhile, the Federal Reserve has increased short term rates several this year causing the shorter-term rates to rise. This leads to a “flattening” of the yield curve where the difference between the shorter-term interest rates and the longer-term ones is decreasing.
It is bad enough that the average for the global yield curve has turned negative. This would indicate the world economy could be in for trouble ahead. The yield curve has successfully predicted every recession since the end of World War II.
Hitting closer to home is the fact that the U.S. yield curve is also sharply flattening towards being negative. The difference (the so-called gap) between two year and ten year U.S. Treasuries amounts to .34 percentage points.
It has not reached these dangerously low levels since 2007 when the American economy was sliding down into the Great Recession (remember this recession proved to be the most severe one since the Great Depression of the 1930’s), as this chart below shows:
If the flattening continues at the pace it has been on, then the U.S. yield curve will be inverted, or negative, by the end of 2018. In the words of the New York Fed President John Williams from earlier this year, such inversions are viewed as “a powerful signal of recessions.”
Remember that all recessions over the last 60 years were predated by such an inverted yield curve, as the San Francisco Fed has pointed out in its March research report. Such yield curve inversions
“correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960’s when an inversion was followed by an economic slowdown but not an official recession.”
Some of the more recent inverted yield curve warnings include the noted inversion of the yield curve from February of 2000. This was immediately before the dot-come stock market bubble burst.
From 2005 through 2006, you saw another one. In this inversion, one yield curve flatted 30 basis points to zero and another one fell 40 basis points to zero in only six months.
Right now the main yield curve is only at 34 basis points. The writing is on the wall.
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