Why We’re Watching the Yield Curve, and Why You Should Care

By Dorothy L. Jaworski, Senior Vice President, Treasurer, Penn Community Bank

In a recent post detailing my forecast for the local economy in Bucks and Montgomery counties and the country as a whole, I described several factors that I and other economists evaluate in making our predictions. Those factors include employment figures, estimates of GDP growth, and the interest rate set by the Federal Reserve, among others.

I also mentioned that one important data point that we look at is the yield curve. For some readers, that may beg the question, “What exactly is the yield curve, and why should I care?” This post should answer that question for you.

What is a Yield Curve?

First: the basics. When speaking about economics and investing, the yield curve refers to a line that plots the interest rates of bonds with different maturity dates. So, it graphs the relationship between the yields of, for example, 3-month, 2-year, 5-year, 10-year, and 30-year bonds. You can check out the daily yield curve rates from the U.S. Treasury here.

In a healthy, growing economy, the yield rates on longer-term bonds are higher than on short-term bonds, so the yield curve slopes upward. That’s a sign that investors are optimistic; they believe the low rate they pay to borrow money to invest in their business now will help generate assets that will grow to be worth more years from now. At one time, former Fed Chairman Alan Greenspan (whom I call the Maestro!) said that a healthy yield curve had at least a .50 percentage point spread between the yields of 2-year and 10-year bonds.

But in December, the yield curve signaled something else entirely. On Dec. 3, 2018, the rate spread between the 2-year and the 5-year U.S. Treasury notes inverted, in the first inversion of the yield curve since 2007. (Note: this was only a partial inversion; I’ll explain more below.)

The Dreaded Inverted Yield Curve

An inverted yield curve – when yields on shorter-term bonds are higher than on longer-term bonds – is viewed as a signal of a looming recession. History has shown that inverted yield curves precede recessions by 18 to 24 months on average, as we saw in 1990, 2001, and 2005. Since 1960, all six recessions have been preceded by inverted yield curves.

Why is an inverted yield curve a bad sign? Because investors become fearful that the economy is slowing, and they tighten their purse strings. Indeed, banks generally pull back on lending if longer-term loan rates are lower than their cost of funds, which are generally based on shorter-term rates. It doesn’t make sense to loan money at a lower rate than you paid to borrow it, yourself.

In December, when U.S. stocks erased all the gains made in 2018 and ended the year down by 4 percent to 6 percent, U.S. Treasury yields for longer-dated issues were declining, too. The spread on 2-year and 10-year Treasuries dropped by .45 percent to .53 percent, respectively, from their November highs. The yield curve on 2-year and 10-year notes continued to flatten to only .19 percent at the end of 2018, down from .52 percent at the end of 2017. The spread between 3-month and 10-year Treasuries was not much better, dropping to .23 percent at the end of 2018, from 1.02 percent one year earlier.

Fears of the dreaded inverted yield curve rippled through the markets as investors worried that the Fed would raise interest rates forever.

The Fed is Listening

In January, though, the Fed listened to the signals the market was sending. The Fed has said repeatedly that they do not want to increase short-term rates if that would cause a yield curve inversion. This led many observers, including me, to believe that they would stop raising interest rates and would, instead, “wait and see.” And that’s exactly what they did.

At its Jan. 29 meeting, the Fed left interest rates untouched, and on Feb. 26, Federal Reserve Chairman Jerome Powell told the Senate banking committee, “This is a good time to be patient and watch and wait and see how the economy evolves.”

That is a good strategy. Federal monetary policy works slowly; it takes time for the markets to feel the impact of Fed decisions, so letting the effects of earlier rate hikes catch up is a healthy approach. Long-term rates have fallen back and should only reverse and trend higher if inflation becomes an issue. So far in 2019, inflation is stable or falling.

Back to that inversion in December: it was only a partial inversion, in that it affected only one part of the yield curve, the 2-year to 5-year spread. However, that spread is not viewed by many as important as the 2-year to 10-year spread, which is considered the true benchmark. If interest rates on 2-year Treasury bonds rise higher than rates on 10-year bonds, that would be a full inversion. As I’ve said before, none of us want that.

As always, the team at Penn Community Bank will continue to track economic indices and data, so we can continue to make the smart financial decisions that have enabled us to remain southeast Pennsylvania’s leading mutual financial institution. If you would like to learn how we can help you make your money work for you, contact our investment advisors at (800) 626-1027 or by emailing invest@pennadvisors.com.

This publication is provided to you solely for educational and entertainment purposes. The information contained herein is based on sources believed to be reliable, but is not represented to be complete and its accuracy is not guaranteed. The opinions, views, and estimates expressed are those of the author at this date and are subject to change without notice. The author cannot provide investment advice but welcomes all of your comments. Investment advisors of Penn Investment Advisors, Inc., a wholly owned subsidiary of Penn Community Bank, can offer investment advice regarding a broad range of securities to clients.