Why are people worried about the US Yield Curve?
You may have seen a growing number of articles out there recently regarding the flattening and inverting of the US yield curve, but what does it mean?
Governments around the world sell bonds with different maturity levels, from the very short-term (eg 3 months) to very long-term (30 years). It makes sense that the longer your money is locked in the higher return (yield) you expect to receive. If we take those yield rates for the various terms and plot them, we can see the yields rise. This is what we call the Yield Curve.
The problem with Yield curves is that they are usually a static snapshot at any point in time. Normally we can not see how the curve changes over time. In Optuma we have added the time element to create what we call a 3D Yield Curve. This animation of the curve shows the 1, 2, 3, 5, 7, 10, 20 and 30 year yields over the last 5 years, with the shorter term (DGS1) on the left and the longer term (DGS30) on the right. The leading edge shows how the curve has flattened in 2018, which is also represented by the two dimensional (or traditional) line in the bottom-right:
Back at the start in December 2013 the difference between the 1 year short-term yield and 30 year was quite steep, as you would expect, but as it advances through time the shorter term yields start to narrow the gap, making the curve appear flatter.
Another way to visualise it is by plotting the yields on the same chart to see how they have recently become much more closely bunched together:
The spread most analysts look at is the 10 year minus the 2 year. Subtraction spreads can be created in Optuma using the custom code builder, but fortunately the St Louis Federal Reserve Bank provide it in their FRED database (symbol T10Y2Y) and is therefore easily accessible in Optuma. Where the value of T10Y2Y is below zero the 10 year has a lower yield than the 2 year, and is therefore negative (or inverted).
The chart below shows where the 10-2 spread has been negative in the past, with the grey shaded areas showing periods of recession:
So why are people worried about the US Yield Curve? When the yield curve turns negative, you can see that it has historically been followed soon after by a period of recession, and with the current yields being so flat people are paying close attention to it. Of course, it may not turn negative, and even if it does there’s no guarantee that the US will enter a recession period, but it is worth keeping an eye on.
The other point to keep in mind is that rates have been very low for the last decade, it was inevitable that rates would start to rise again and when they do, it is the short term rates that will rise first. As longer term bonds roll over, we should see those yield beginning to increase too.
Optuma clients with access to the FRED database can click the button to download the workbook and open the yield charts shown above.
Darren Hawkins, MSTA
Senior Software Specialist at Optuma
Darren is the senior Software Specialist at Optuma. He joined the company in 2009 after attending an introductory technical analysis course. Darren now instructs users all over the world, from experienced Wall Street traders and professional money managers to individual traders drawing their first trendlines.
Darren grew up in the UK and attended college in the USA where he earned a BA in Economics from St Mary's College of Maryland. He went on to spend a few years working at the Nasdaq Stock Market in Washington DC. Going on to live and work in Australia, the US and currently the UK, Darren has a broad understanding of the individual needs of traders, portfolio managers and investors utilising a wide range of methodologies.
In 2014 Darren passed the UK-based Society of Technical Analysts diploma course, and hopes to have passed Level 3 of the CMT Program in December 2018.
When not looking at charts, Darren keeps a keen eye on England's cricket team - especially if they are playing against Australia. He lives in the Essex countryside in England, with wife Wendy and their labrador, Gabba.