The Treasury Yield Curve Has Flattened: Why That’s Bad News for Economic Growth and Inflation
Financial news has been rife with updates on the Treasury yield curve inverting between 20 and 30 years last Thursday — but what does that mean, and how could it affects you?
The U.S. Treasury Department finances the federal government debt (commonly referred to as “obligations”) by issuing its own various forms of debt. This means Treasury bonds, and the $14.8 trillion Treasury “market” include everything from T-bills, T-notes and 20- and 30-year bonds.
Investors of all kinds can purchase these instruments, and each has its own function. T-bills, or Treasury bills, have expirations from one month up to a year. Treasury notes, T-notes, have expirations from 2-10 years and Treasury bonds have maturities of 20 or 30 years.
The “yield curve” plots the yield of all of these Treasury securities, and investors watch its “shape” to estimate market movements and conditions for everything from interest rates to monetary policy.
United States Treasury bonds are considered to be one of the safest investment products in the world, and international markets use their value, and movements, as a benchmark for economic security — or volatility. The 10-year Treasury bond is considered the benchmark for most 10-year bonds in the market. All U.S. Treasury bonds are backed by the full faith and credit of the U.S. government, as the country has yet to default (although we are coming uncomfortably close) on its creditors, making it one of the most credit-worthy nations in the world.
Economy Explained: What You Should Know About the Inverted Yield Curve and Economic Trouble
Your typical yield curve looks like any regular scatter plot — as values increase on the x-axis, so do the values on the y-axis.
The curve typically slopes upwards, because “investors expect more compensation for taking on the risk that rising inflation will lower the expected return from owning longer-dated bonds,” according to Reuters. This means that T-bills, which expire quickly, will yield — or give you back — a small amount of money. You are taking little risk compared to other investors, as you are holding the security for a short amount of time. Investors prefer these kinds of investments if they want to park cash somewhere and be certain to receive it back. They also pay a fixed rate of interest, which is typically very low.
The most important concept to remember in the bond space is the inverse relationship between interest rates and bond prices. But why?
Bonds pay a fixed rate of interest. This can be attractive to investors to lock in an interest rate if they believe interest rates are to fall, as the rates will fall but they will still collect a higher interest rate on their already-purchased bond. This increases the demand for higher yield bonds, thus driving up the price. Should interest rates rise, the bonds with the lower yield will become less attractive, as investors will favor bonds with higher yields paying out higher certain rates of interest. This will cause the price of bonds to decrease.
Glitches in the System
Throughout the past couple of decades, the yield curve has sometimes inverted, a phenomenon that Reuters reported as “bad news for the short-term economic outlook” and a warning sign of past recessions.
Ordinarily, as seen in the above picture, the yield on the 30-year bond would be higher than all other bonds, as it has a higher time horizon. On Thursday, though, the yield on the 20-year bond rose above the 30-year bond.
In finance, this is called a “flattening” of the curve or referred to as the curve being “inverted,” essentially because it is not behaving as it theoretically should. Instead of the relatively smooth upwards trajectory of the yield line (which slightly curves, thus the name), a “dip” happened last week that ruined or “inverted” the rightward and upward trajectory across the axes.
Why Is This Happening Now?
The past year has been tumultuous for prices, to say the least — inflation is up a whopping 6% after staying at historic lows for the better part of the last decade. While the Fed maintained steadfast in its goals earlier this year to delay raising interest rates until late 2022/early 2023, current market conditions may force an earlier hand.
The Federal Open Market Committee is widely expected to announce at their meeting tomorrow that it will begin tapering its bond buying program.
Government bond yield curves have been flattening all over the world as central banks are expected to move toward ending the era of loose-monetary policy put in place at the beginning of the pandemic, Bloomberg added.
As the committee members gear up for their meeting, investors likely wanted to rid themselves of positions in anticipation of news that an interest rate hike is officially coming sooner than expected. Central bank policies that tighten money, or raise interest rates, often lead investors to expect slower economic growth and inflation.
See: Consumer Sentiment Remains Low, Gains Edged Out by Highest Rate of Inflation Uncertainly in ‘Nearly 40 Years’
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With runaway inflation experienced in the past year, the only path of recourse might mean raising interest rates. The reason the decision would be so historic is because rarely does a central bank take this action with unemployment problems and unstable overall market conditions. The U.S. economy, although greatly improved from the heights of the pandemic, has yet to see full economic lift-off.
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Last updated: November 2, 2021