Economics & Markets

What is a yield curve and why is it flattening?

By Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist, AMP Capital Sydney, Australia

AMP Capital Chief Economist Shane Oliver says investors should keep a watching brief on a flattening yield curve, but it is not yet signalling a sharp economic slowdown or recession in the US.

“It’s certainly something worth keeping an eye on,” he says. “But I don’t think we’re at that point yet where this is indicating a recession is around the corner. We’re a long way from that point.”

There has been growing alarm that a flattening yield curve, particularly in the US, is presaging a slowdown in global growth.

The yield curve is the gap between long-term bond yields (usually 10-year bond rates) and short-term interest rates (usually the official short-term rate and sometimes the 2-year bond yield).

Under benign economic conditions, the yield curve typically slopes upward from left to right with short-term rates much lower than long-term yields.

But the US Federal Reserve has been raising official rates, which has increased the Fed Funds rate and 2-year bond yields. At the same time, long-term bond yields have been stable or falling slightly.

“Consequently, the gap between the two – the long long-term yield and short yield – has narrowed a little bit and people call that a flattening in the yield curve,” Oliver says. “We have seen flattening in yield curve led by the US mainly.”

Oliver says there are reasons a flattening yield curve should worry investors. “Obviously it signals tightening of monetary policy as short-term interest rates go up relative to long-term interest rates.”

But the bigger concern is that when the yield curve goes negative – with short-term yields higher than long-term yields (the yield curve sloping down from left to right) – the move is seen as a possible indicator of an economic downturn.

“Historically when it’s gone negative in the US, some of the time it leads to slower economic growth and sometimes a recession,” Oliver says.

Oliver says a negative yield curve would be a definite worry for investors. “Are we concerned? Yes. If it goes negative, then that would be a big concern; it would suggest that maybe there is a recession around the corner.”

He notes that in the past the yield curve flattening has given false signals. “Sometimes it’s gone negative and we don’t get a recession,” he says.

The lag between a yield curve becoming negative and recession can also be a very long time. “You can go negative, but it can take a while before you get that recession coming through.”

But, most importantly, the yield curve hasn’t gone negative and there is no cause for alarm just yet. “At this stage it’s still not pointing to a recession,” he says.

Oliver says the flattening so far could represent a readjustment after a period of record-low interest rates. “You can say we’ve gone back to something approaching what is more normal because we had that environment with zero interest rates. They [official interest rates] have now come up so we’re going back to something a bit more normal.”

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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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