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Yield Curve Anxiety

John Rowland

Posted on December 22, 2018 21:03

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There are certain fairly reliable economic indicators in terms of predicting/indicating a recession; the yield curve is one of them.

When it comes to assessing whether the economy is good or bad, many retail-level investors maintain a keen eye on the equity stock markets. The Dow goes up, folks feel good, then usually turn their attention to something else not economic related.

The volume of bonds in economies is actually much larger than that of stocks. The bond market's behavior is really a better leading indicator of the economy's performance and direction than stocks.

The trading in these bond markets affects the value of the traded debt securities -- as indicated by the price and yield of those securities.

The yield curve chart is one way to gauge the general relationship between debt money maturing in the short-term and debt money maturing in the long-term.

This is normally a proportional relationship: shorter-term maturities have lower interest rates; longer-term maturities have higher interest rates.

It makes sense. If you choose to lend someone money for a longer period of time, you will want to be compensated for that added time and risk at a greater level; voilà, a higher yield.

So when the interest rate spread between the 2-year debt instrument and the 10-year debt instrument narrows, something's usually up. This is typically described as a flattening of the yield curve.

In economic terms, does everybody remember 2008?

It's happening again. Check out this graph from Bloomberg.



The spread between the 2-year and 10-year rates has "dwindled below 15 basis points," the flattest since 2007.

The flattening of the yield curve can be a transitionary move towards an actual inverted yield curve -- where short-term rates are higher than long-term rates.

Some have claimed this inversion has already begun.

There is a long, credible economic history to suggest that an inverted yield curve basically indicates recession-type conditions.

Part of the reason for the reduction in long-term rates is that investors want to lock in a higher rate of return in advance of adversarial economic conditions; so they buy these long bonds, thereby bidding down their yields.

With the central planners at the Federal Reserve increasing short-term interest rates last week, the drama picks up.

So everybody hang on to your hats . . .

John Rowland

Posted on December 22, 2018 21:03

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Africa's biggest economy is officially in recession.

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