Explainer: The US yield curve has flattened: why you should care

The Federal Reserve Building is seen in Washington, U.S., January 26, 2022. REUTERS/Joshua Roberts

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NEW YORK, March 17 (Reuters) – The U.S. Treasury yield curve flattened further on Wednesday as the Federal Reserve raised interest rates for the first time in three years and set tighter monetary policy to fight inflation relentlessly. Read more

The shape of the yield curve is a key metric that investors watch because it impacts the prices of other assets, feeds through to bank yields, and has been an indicator of how the economy is changing. The recent moves have reflected investor concerns about whether the Fed can tighten monetary policy to tame inflation without hurting economic growth.

Here’s a quick primer explaining what a steep, flat, or inverted yield curve means and whether the current shape of the yield curve predicts a recession.

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WHAT IS THE US TREASURY YIELD CURVE?

The US Treasury funds the federal government’s fiscal obligations by issuing various forms of debt. The $23 trillion Treasury market includes Treasury bills with maturities of one month to one year, two-year to 10-year notes, as well as 20- and 30-year bonds.

The yield curve represents the yield of all Treasury securities.

WHAT SHOULD THE CURVE LOOK LIKE?

Typically, the curve slopes upward because investors expect greater reward for taking the risk that rising inflation will reduce the expected return from holding longer-dated bonds. This means that a 10-year note generally pays more than a 2-year note because it has a longer duration. Yields move inversely to prices.

A steepening curve generally signals expectations of stronger economic activity, higher inflation and higher interest rates. A flattening curve may mean the opposite: investors are expecting short-term rate hikes and have lost confidence in the economy’s growth prospects.

WHY IS THE YIELD CURVE FLAT NOW?

Yields on short-term US government debt have risen rapidly this year, reflecting expectations of a series of rate hikes by the US Federal Reserve, while yields on longer-term government bonds have moved at a slower pace amid fears that policy tightening could hurt the economy.

As a result, the shape of the Treasury yield curve has generally flattened. A closely watched part of the curve, measuring the spread between two- and 10-year Treasury yields, showed the spread at 24.5 basis points on Wednesday, more than 60 points lower than at the end of 2021. This flattening increased on Wednesday after the Fed raised rates.

While rate increases can be a weapon against inflation, they can also slow economic growth by increasing the cost of borrowing for everything from mortgages to auto loans.

Two-year US Treasury yields, which track short-term interest rate expectations, rose to 1.94% from 0.73% at the end of last year, an increase of 166%.

Benchmark US 10-year yields rose from 1.5% to around 2.19%, an increase of 46%. In February, they exceeded the 2% level for the first time since 2019.

WHAT DOES AN INVERTED CURVE MEAN, AND WILL IT HAPPEN?

Some investors and strategists have predicted that a curve inversion could occur, with short-term yields exceeding long-term yields, as early as this year – an ominous sign.

The U.S. curve has reversed before every recession since 1955, followed by a recession between six and 24 months, according to a 2018 report by researchers at the Federal Reserve Bank of San Francisco. It only offered a false signal once during this period.

The last time the yield curve inverted was in 2019. The following year, the United States entered a recession, albeit caused by the global pandemic.

DOES THE WHOLE CURVE REVERSE OR PARTIALLY?

Traders typically watch the shape of the curve determined by comparing two-year and 10-year Treasuries, as an inversion of the yield curve on this spread anticipated previous recessions. This curve is flattening but is not yet close to reversing, with a spread down to 24.5 basis points on Wednesday against 29.10 the day before.

But distortions can occur anywhere along the curve without inverting the whole curve.

On Wednesday, the 5s/10s curve reversed in intraday trading. It returned to positive territory, but the spread fell to 0.4 basis points from 3.8 the day before.

A less closely watched part of the curve has inverted several times in recent weeks, with the premium of 10-year U.S. Treasuries over seven-year Treasuries closing in negative territory every day since March 11. .

The 20y/30yr spread has been negative since late October, although technical supply and demand factors may have contributed.

WHAT DOES THIS MEAN FOR THE REAL WORLD?

In addition to the signals it can send about the economy, the shape of the yield curve has ramifications for consumers and businesses.

When short-term rates rise, U.S. banks tend to raise their benchmark rates for a wide range of consumer and commercial loans, including small business loans and credit cards, making borrowing more expensive for consumers. Mortgage rates are also rising.

When the yield curve steepens, banks are able to borrow money at lower interest rates and lend at higher interest rates. Conversely, when the curve is flatter, their margins tighten, which may deter them from lending.

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Reporting by Davide Barbuscia Editing by Chris Reese

Our standards: The Thomson Reuters Trust Principles.

About Meredith Campagna

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