Is a flattening yield curve a precursor of recession?

by Sam Sudame, Singer Xenos Schechter Sosler Director of Research

Lately there’s a lot of talk about an economic indicator called the yield curve, dubbed by some pundits a near-infallible prognosticator of a recession on the horizon.

Briefly, the yield curve charts the difference between interest rates on short-term United States government bonds, such as two-year Treasury notes, and long-term government bonds, like 10-year Treasury notes. In a healthy economy, the interest on long-term bonds is consistently higher. If those numbers should invert and the interest on long-term bonds slips to the lower position, very often a recession is triggered.

Due to fears of global trade wars and tighter Federal Reserve policies aimed at containing inflation, the difference between the two is flattening. It’s now only 0.34 percentage points, a low last seen in 2007 – just before the Great Recession.

However, we don’t see grounds for panic. The yield curve is not a crystal ball. No single indicator is. At Singer Xenos Schechter Sosler, while the yield curve is one of our key indicators, we consider it in conjunction with other leading economic indices, such as credit spreads and the University of Michigan Consumer Sentiment Index. So far, not only has there been no inversion of the yield curve, but no other indicators point to a recession in the short term.

We do advise caution. The U.S. is now in one of the longest economic cycles in its history. As cycles age, the market becomes more vulnerable to external shocks. We should, therefore, expect the narrowing of the yield curve to be accompanied by jitters in the stock market. If large numbers of investors start buying up long-term bonds, that in itself could force an inversion.

A flattening yield curve is particularly harsh on lenders, whose profit depends on higher long-term rates. When access to capital is constricted, economic growth is compromised.

In these uncertain times, we stress the importance of investing in high-quality assets and mitigating risk through diversification. We advise our clients to keep the volatility of their portfolios in line with total market volatility and to maintain minimal leverage. With careful monitoring of the market, we can help smooth the ride as the road becomes bumpier.