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A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Will the Flattening Yield Curve Lead to Recession?


This is a confession of sorts. for most of my adult life, I have observed and thought about the yield curve far more than any normal person should. What had been a private obsession has suddenly become an object of intense scrutiny and discussion in the financial world, including in many quarters that previously had paid little notice to this indicator.

To review, the yield curve traces the yields on varying bond maturities, from the shortest—three months or less—out to as far as 30 years. U.S. Treasury securities are universally used as the basis because of their absence of credit risk, which makes them the benchmark for all dollar-denominated debt.

The curve typically slopes upward, with shorter maturities yielding less than intermediate and long ones to compensate for the risk of locking up an investment for a lengthier period. The real key to the curve and its slope is what they imply about investors’ expectations about future interest rates and the economy. If investors expect higher interest rates in the future, they will demand higher yields on longer bonds to compensate, in turn lowering the price of older bonds; in that case, the curve’s slope would tend to steepen. Conversely, if they expect lower rates, they would try to lock in current yields before they fall, and bid up the bonds’ prices and lower their yields, probably resulting in a flatter yield curve. To be sure, this is an oversimplification. But this is the basic idea.

Those expectations about future interest rates are intertwined with the outlook for the economy and inflation; strengthening of those measures augurs higher yields, and vice versa. Those factors obviously also drive the Fed’s monetary policy decisions.

What has gotten the yield curve back into the headlines has been its steady flattening, specifically the sharp narrowing in the spread between the 10-year Treasury, the bond market benchmark maturity, and the two-year T-note, the shortest coupon maturity. Last week, the spread hit 18 basis points, and ended the month at 21 basis points, the lowest month-end reading since it got down to 16 basis points in June 2007, according to St. Louis Fed data. (A basis point is 1/100 of a percentage point.)

The significance is that when the spread between the two- and 10-year note hits zero, a recession invariably follows. With the spread just a chip shot away from nil, warning flags should be flying for the economy—notwithstanding 4%-plus gross-domestic-product growth in the second quarter (and continuing at 4.1% in the current quarter, according to the Atlanta Fed’s GDPNow model estimate), plus most of the major stock market averages hitting records... 

These financial indicators don’t yet signal an impending recession. Does that mean the message of the flattening yield curve should be ignored? At your peril.

The Economic Cycle Research Institute’s array of indicators point to a “stealth cyclical slowdown,” according to Lakshman Achuthan, its co-founder. The growth rate of the ECRI Weekly Leading Index is unambiguously downward, reaching zero in its latest reading.

And in contrast to the latest robust GDP readings, ECRI’s broader U.S. Coincident Index is below last October’s peak. “That’s pretty remarkable because we’ve had massive fiscal stimulus on top of an energy production boom,” he writes in an email.

Bottom line, ECRI’s Weekly Leading Indicator is “telling us in no uncertain terms that economic growth will ease in coming months,” but not fall into a recession, Achuthan concludes. That’s consistent with the message of the yield curve, which may explain why I’m obsessed with it.

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