What does a flattening yield curve actually indicate?
The rally of the stock market last week seems to give a boost in many investors' confidence, recording the best weekly gain in almost 16 months. Is the latest stock performance forecasting a bright road lies ahead, or the jury is still out on the rebound of the market and it's just a reprieve on something worse to come, probably an economic recession?
The R-word has been brought up quite frequently of late, signaling increased concerns over the future economic condition. With plenty of uncertainties surrounding the market, such as geopolitical issues, Covid-19 pandemic, inflation, and Fed rate hikes, some analysts start to worry about the probability of a recession, especially when the recent yield curve shows continuing signs of flattening. What is yield curve flattening? Why everybody is eying on this indicator?
What is a yield curve?
The yield curve is a two-dimensional plot of the interest rates on bonds for different maturities, with yields on the y axis and maturities on the x axis. The normal form of yield curves slopes in the upper right direction and the deformed yield curves show flattening shapes, or even worse, inverted shapes. Before we dive into the infamous flat yield curve and the inverted yield curve, there's one more definition to explain.
What is yield spread?
The yield spread is the difference between long-term yields and short-term yields. Typical yield spreads can be 10Y-2Y, 10Y-3M, and 10Y-Federal Funds Rate. (Federal Funds Rate is the interest rate Fed charges major banks by lending money to them that will be returned overnight) When the yield curve is steep, yield spreads are positive. If yield spreads slowly move towards zero or even become negative, the yield curve will present the phenomena of "flattening" and "inverted".
Why are “flattening” and “inverted” alarming?
There are some charts below.
Shaded areas denote recessions.
The inversion of the yield curve tends to happen at the same time a bear stock market begins, where S&P 500 declines 20% or more. Plus, inverted yield curves usually precede economic recessions. No wonder plenty of analysts keeps a close eye on this indicator. Once it shows a tendency to flatten, there might be something worse looming in the darkness.
Why does the inverted yield curve have such a predictive power?
This is totally another huge topic here. To be succinct, the yield curve can predict future monetary policies, and it can be indirectly referenced when timing a recession. But it has no causal relationship with economic recessions. It's those monetary policies predicted by the yield curve that have caused financial crises, which are credit crunch, that incur economic recessions. Yet negative yield spreads almost coincide with an economic downturn, that's why it can be served as an effective tool for investors.
One can simply regard long-term yields on the yield curve as future interest rates the Fed will set its target rate around. If the yield curve is steep, then investors are expecting the Fed will increase the Federal Funds Rate in the future, since current low rates are prone to incur high inflation, which can be tempered by raising interest rates. Similarly, if the yield curve is flattening, investors think rates will remain the same in the long term, without the worry of future inflation. An inverted yield curve threatens the market by the expectation of future recessions, so the Fed has to lower rates to inject funds into the economy to recover it.
Therefore, the yield curve predicates future monetary policies. An inverted yield curve shows the current monetary policy is so tightening that it will cause financial crises, thus the market set the long-term yields at a lower level to brace for a recession.
What does the current yield curve look like?
This is the yield curve after the market ended on March 21st. The curve has flattened significantly compared to the previous two years, especially in the range from 2 years to 10 years. This chart tells us that current interest rates are still too low in the short term to fight off the rampant inflation. Thus investors expect the continuous rise of interest rates in the next two years if the Fed wants to bring inflation back to the normal level. From 2 years to 10 years, interest rates don't differ too much, signaling that inflation is likely to be brought down in the long-term, and Fed doesn't have to raise interest rates anymore. It's still not inverted though, so the current market doesn't expect a recession is around the corner. But there's a smell of danger now, with the Russian-Ukraine conflict opening an astonishing round of inflation in commodity prices.
The Fed is treading a tight rope now, afraid of being aggressive to trigger a recession. At least right now, monetary policies are not as hawkish as investors have expected, with a 25bps rise last week. But will current policies be effective enough to bring inflation down? There's so much uncertainty down the road.
Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only.
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Talklili : Does the investment environment really have a big impact?
Stuka II Talklili: Oh I bet it does. See the correlation between Fed balance sheet past QE trend and ongoing tapering trend with SPY QQQ
Stuka II Stuka II: And let’s see what the further QT measures stored for the stock market. Yield curve could be a good gauging instrument tho
Moomoo News GlobalOP Talklili: Yes it is. Stock prices are driven up by money inflow. When QE was implemented, the market went up a great amount. Yet people worry about a tightening cycle now since it’s gonna decrease capital into the stock market, which will drag prices down.
Moomoo News GlobalOP Stuka II: It’s true. Everybody is watching the yield curve now.
Moomoo News GlobalOP Stuka II: That’s right. QE will boost the market a lot while QT is a little concerning.
Talklili Moomoo News GlobalOP: Okay, I hope more capital can flow in. Of course, we also need a reasonable portfolio to separate the sharp drop in prices.
Moomoo News GlobalOP Talklili: Later I will post some articles explaining some hot sectors in this environment. Hope that will help more investors in moomoo.