Borrowers: The Flat Yield Curve May be Your Friend
With all the talk of the flat yield curve in the financial media these days, and the impending doom and gloom it supposedly foretells, it’s a good time to get back to basics. If you’ve questioned your understanding of yield curves recently, now’s your chance to get caught up. In the paragraphs below, we’ll review what a yield curve is, what different versions of it really mean, what the current flat curve is telling us about the future and opportunities it offers to hedgers of interest rate risk.
What’s a Yield Curve Anyway?
The yield curve is a line that plots the annual interest rates paid on bonds of various maturities, typically ranging from one month out to 30 years. The line or “curve” is a snapshot of interest rates, referred to as “yields” at a set point in time. Yields on longer-term bonds, say 10+ years, tend to be higher, reflecting the time-driven risk the owner of the bond incurs in holding it to its maturity. The primary risk to bond holders is inflation, and its ability to erode the value of the fixed payments or “coupon” the bond pays to its owner over time. Bondholders hate inflation and will often bail out of their bond investments at any hint of it in pursuit of other, inflation-friendly investments, like stocks.
Interpreting the Curve
Analysts look at the yield curve’s shape or “slope” for insights into the future direction of interest rates and future economic performance of a given economy. There are four main types of yield curve shapes:
- What it is: A curve in which longer maturity bonds have a higher yield than those of a shorter maturity.
- What it means: Due to the uncertainty related to time, a rising yield curve illustrates investors demand a higher return (yield) on longer maturity bonds over those of shorter maturities.
- Implications for the future: Indicates that longer-term interest rates may rise, as a direct response to economic expansion. Investors demand an increasing return from their bond holdings when faced with other, high return alternatives which exist in an economy that’s growing at a healthy pace.
- What it is: A more extreme version of the rising yield curve above, a steep yield curve is one in which long-term interest rates are significantly higher than shorter term ones, making the curve appear “steeper”.
- What it means: A rising yield curve becomes steep because bond holders expect rapid economic growth, rising inflation, and much higher interest rates in the future.
- Implications for the future: A yield curve steepens because of a high likelihood that the Fed will, or already has, begun raising interest rates to combat the looming, corrosive effect of rising inflation.
Flat (where the current Treasury yield curve has been heading)
- What it is: A curve in which longer-term maturity bonds have a similar yield to those of a shorter maturity. A transitory state of a yield curve, which could manifest from either the Inverted or Rising curve outlined above/below, as the difference in long-term and short-term yields (aka “spread”) decreases.
- What it means: Suggests falling expectations of inflation in the future. As described above, investors demand a higher return from longer maturity investments due to the uncertainty of time. When inflation becomes less of a concern, investor’s demand for higher long-term yields wanes.
- Implications for the future: Indicates an anticipation of lower inflation and slower economic growth. Sometimes, the yield curve flattens because short-term yields rise near the level of long-term yields because of the expectation the Fed already has and will continue to raise interest rates in the future.
Inverted (what some say is our destination)
- What it is: A curve in which longer maturity bonds have a lower yield than those of a shorter maturity.
- What it means: Usually, but not always, implies that an economic recession lies ahead. Suggests yields on longer-term bonds may continue to fall as investors seek the safety of a long-term bonds, as they pay a fixed payment in times of looming economic turmoil, with investors even choosing to purchase the long-term bond before its yield falls even further.
- Implications for the future: Indicates a high likelihood that the Fed will, or already has, begun cutting interest rates to offset a current or looming economic slowdown.
Economists and the Fed routinely examine the yield curve for clues on what the bond market thinks about growth and inflation. One of the most commonly analyzed yield curves is that of US Treasuries. To summarize it all in the context of US Treasuries, the Treasury yield curve measures the yield difference between short and long-term debt issued by the US government. It measures the extra compensation – in basis points – that investors demand to invest in Treasuries for an extended period. A large yield spread = a steep curve. A small yield spread = a flat curve. Got it? Said another way, the “flatter” the yield curve, the smaller the spread between short and long-term yields. Right now, the Treasury yield curve is somewhere between Rising and Flat, and has been “flattening” consistently for years.
What Treasury Yield Spreads Look Like Now
Treasury yield spreads (again, the difference between long and short term yields and a handy way to measure the “steepness” or “flatness” of a yield curve) have been ticking steadily lower for some time now across the universe of Treasury maturities; yield spreads on the 2 and 10-year, the 2 and 30-year, the 5 and 10-year and the 5 and-30 year curves are now the flattest they’ve been in a decade. The flattening Treasury curve also translates into similar flattening curves for LIBOR and the Swap rate, an important dynamic for floating interest rate borrowers.
What a Flattening Curve Means
It’s a scenario that illustrates the market’s expectation for future interest rates is in stark contrast to the Fed’s pronouncement that it intends to hike two more times in 2018 and at least twice in 2019. The Fed, by way of its pronouncements of future hikes, pushes short-term rates higher and markets, via their lingering doubts in the need for hikes in the first place due to minuscule wage growth and scant inflation, push long-term rates lower. Only until recently have we seen long-term rates nudge higher (e.g. the 10-year Treasury breaking and staying above 3.00%), relieving some pressure off the incessant curve flattening, but pretty much everyone believes the flat Treasury curve will likely persist for some time. It’s important to remember that markets and the Fed disagreeing on the future direction of interest rates isn’t anything new. What’s different this time is the great divergence of opinion, the resulting degree to which yield curves have flattened and what flattening curves imply for the future.
Yield Curves and Recessions
If the divergence of opinion continues, the Treasury yield curve will flatten even more or even invert next year. As stated above, an inverted yield curve is one where short-term yields are higher than long-term yields – an extreme scenario where the Fed hikes sequentially or threatens to keep doing so, and markets don’t buy into the Fed’s “we’re hiking because inflation is around the corner” narrative. Inverted yield curves have appeared in markets on several occasions over the last half-century and were followed by a recession within a year or so afterward. So much so that inverted yield curves have become a widely accepted market alarm for a looming economic recession:
While its true that an inverted yield curve has historically presaged an eventual recession, the financial media would have you believe that a recession occurs right after the yield curve inverts. That somehow, as the yield curve flattens the economy gets steadily worse until the yield curve finally inverts and BAM! Economic disaster strikes. While the scenario is exciting to contemplate, it’s simply not true, Here’s why:
- When the Fed is in the midst of a tightening cycle, like it is right now, the yield curve should flatten. As the Fed hikes the Fed Funds rate, a short-term interest rate, it lifts the “short end” of the yield curve, making the curve flatter and narrowing yield spreads,
- Flat yield curves don’t always invert. While the financial news media has implied that the current flattening yield curve will invert, we’re doubtful. Flat curves can remain flat for years without ever inverting, as they did in the 1990s, while the economy continues to grow. In the meantime, the yield curve is also likely to get even flatter, as the Fed continues to hike short-term rates to prevent the economy from overheating and any real inflation pressure remains scant,
- A “less steep”, but positively sloped curve doesn’t necessarily mean economic bad news. Historically, there have even been substantial time lags between curve inversion and a recession, by many months at a minimum and sometimes even years.
What’s Really Causing the Curve to Flatten
There’s lots of talk going around lately about the US government’s ballooning budget deficit, the necessary, looming large US Treasury bond and note sales needed to finance it, and how they will impact interest rates down the road. Further, markets want to know if the swelling financing gap will sway the Fed’s outlook for rate hikes.
The Federal deficit isn’t a problem that will be solved anytime soon, so we like to think about it in terms of how the ensuing Treasury bond issuances affect he Treasury yield curve and how the curve predicts future interest rates and the economy. So far this year the US Treasury’s increased bond issuance has focused on shorter maturities, and, combined with the December 2017 and March 2018 Fed rate hikes and expectations for more hikes in the near future, has been a major contributor to the flat Treasury yield curve. If you didn’t catch it earlier, to put it into perspective, the difference between two and 10-year Treasury note yields is less than half a percent.
Your Ultimate Take-Away
Now that you have the yield curve knowledge to be the smartest – or the most boring – person at your next cocktail party, here’s what you really need to know: The flattening yield curve offers borrowers unique but temporary opportunities to achieve the ultimate goal of:
1) creating the longest stream possible of known interest expense, and
2) to drive down interest expense over time.
Most of the time, these goals are mutually exclusive, but there are times when they’re not, and organizations must act strategically to take advantage of opportunities to accomplish both goals when it exists. The need to hedge future term financing has come back vigorously, and fortunately, recent financial market conditions – including ever-flattening yield curves – allow for a much better way to hedge the risk of rising interest rates by employing lesser used derivatives like Swaptions and interest rate Collars, many of which haven’t looked this good in years. In the current world of higher interest rates, smart borrowers aren’t fearing the flat yield curve, they are examining how the flat yield curve can work for them. Talk to us and learn how.
Current Interest Rates