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Tatton Asset Management Plc

Yield-curve flattening: a bad omen?

After equity markets saw one of their longest winning streaks for quite some time, a bit of push-back from nervous traders and investors was probably inevitable. As if our lead article of last week had jinxed markets into action – sure enough – this week saw the longest streak of falling global equities since March. Before we get ahead of ourselves here, we should point out that this ‘losing’ streak means consecutive days of declining market value and not the actual amount that markets have lost – the actual decline has been a modest 1-2% across most regions. Still, no good mood goes unspoilt for too long, it seems.

Amid the worries we’ve seen about markets running too hot and valuation levels becoming unsustainably high, a market hiatus like this gives the bears (those expecting market declines or even recession) a chance to scout for evidence that all is not well. Unfortunately, it looks as though they’ve found some.

Over the past year, yields on two-year US Treasury bonds have risen around 0.7%, while yields on ten-year Treasuries have risen only 0.12%. In finance terms, this is called a flattening of the yield curve – a narrowing of the term spread (the yield difference) between short and long-term bond yields. Normal yield curves tend to slope upwards, as longer-term bonds come at a yield premium to those with shorter maturities, due to the longer lock-up until the bond matures. This ‘normal’ situation is supposed to indicate market confidence in a country’s short-term economic prospects (provided the yields aren’t just high across the entire curve). Conversely, a flattened or (especially) inverted yield curve – where long-term bonds yield the same or less than short-term ones – indicates a lack of confidence.

Why does this matter? The yield curve is usually one of the more reliable general indicators of economic prospects (in the US at least). An inversion of the treasury yield curve has preceded every US recession since the 1960s (and there have been no ‘false alarms’ – inversion but no recession – see the chart below – whenever the blue line has dropped below 0, recession soon followed). More than simply reflecting markets’ verdict on the economy, the yield curve also has a big effect on bank profitability. Banks make money off the spread between short and long-term yields, borrowing or taking deposits at the short end and lending at the long. When the spread tightens, a major source of profit dries up, and with it the banks’ lending ability. This cuts off financing to the real economy, choking opportunities for growth.

So, naturally the current flattening has many investors worried. Should they be? Short answer, not really. Long answer…

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Disclaimer: Statements in this article should not be considered investment advice, which is best sought directly from a qualified professional.