Understanding the flattening yield curve and the next recession

The three words causing more heartburn for investors and analysts this summer are these: Flattening yield curve.

If you watch markets or economic news at all, you know this is a hot topic that many believe will predict the next economic recession in the U.S. So, let's use the blog this week to go over the basics of the yield curve, what it means, how it becomes flat – or worse, inverted – and what that means for all of us.

What is the yield curve?

The yield curve is simply the difference between bond maturities and interest rates, or yield, paid on those bonds. The most common yield curve, and the one in the headlines today, is the curve between short- and long-term US Treasury bonds.

Under normal circumstances, the yield on these bonds increases from shorter-term bonds, such as the 2 Year Treasury note, to longer-term bonds, such as the 10 Year note. Normal economics would call for higher interest to be paid on bonds held by investors over a longer term. The longer the term to maturity, the higher the rate of interest, or the yield.

However, at times, the curve can flatten or become inverted when economic health is out of whack or investors begin to fret. In these cases, short-term rates begin to equalize with long-term rates (flattening) or flip places and short-term rates exceed long-term (inverted curve).

Why is the yield curve flattening today?

Recently, we've seen the yield curve flatten. This summer, the difference between the yield on a short-term 2 Year Treasury note and a long-term 10 Year Treasury note has been as low as 25  basis points. This is the lowest we have seen since early 2007. It's not yet inverted, but it's getting closer.

This is happening for several reasons. The two most simple to understand are rising short term rates and uncertainty creating an appetite for long-term bonds. Let's unpack this.

First, rising rates. After years of monetary stimulus, the Federal Reserve is now scaling back its balance sheet and increasing short-term rates. The Fed has already hiked rates twice this year, and most investors expect one or two more increases by Dec. 31. So, naturally, rates on short-term government bonds are rising. This is an attempt to normalize monetary policy and prevent the economy from overheating quickly after years of added stimulus.

However, long-term bonds haven't increased at the same rate. This is the second piece of the puzzle. As short-term rates are rising, investors are continuing to buy 10 Year Treasury bonds, which has kept their yields comparatively low.

This is simple supply and demand. If investors were buying fewer long-term bonds, then prices would fall and yields would rise. But we've seen the opposite at times this summer. Investors continue to flock to long-term U.S. government bonds because they are seen as the safest investment in the world. With trade wars, political unrest and uncertainty about how much longer the U.S. economy can keep expanding and the continued struggles in the world economies investors have remained invested in long-term bonds, keeping their yields in check, as short-term yields increase at a faster pace.

If the trend continues, the yield curve could become inverted within the next 12 months, perhaps as early as the end of this year

What does this have to do with recessions?

Over the last 50 years or so, an inverted yield curve has preceded every U.S. economic recession. There have been a couple short-lived false alarms, but investors are right to see this yield curve as an indicator of a recession. Just keep in mind: It is an indicator, not the cause of a recession.

For example, from 2006 to 2007, the yield curve inverted as the Federal Reserve hiked short-term interest rates rapidly hoping to cool off the asset bubble in housing that many believed was caused in part by low interest rates for too long. What happened next? The 2008-2009 "great" recession.

Today's scenarios are much different as asset prices haven't grown as rapidly as those in the mid-2000s. And Fed rate hikes today are proceeding more modestly. Still, the flattening of the curve has been driving speculation that a recession could be a year or two away.

What the yield curve doesn't show us are the various factors that would actually cause a recession. So, watch this curve as a potential indicator, not a definitive factor in economic health.

What's next?

Keep an eye on how quickly the Fed continues to raise interest rates and where investors are putting their money. If the Fed keeps pushing short-term rates higher, but a strong labor force, recent tax cuts and other pro-business policies encourage private-market investment and growth, we could see the yield curve keep a more typical curve rather than flatten further.

However, if short-term rates keep going up while investors remain cautious, buying long-term US Treasury bonds as a safe haven, then an inverted yield curve is going to happen.

Keep in mind as mortgage professionals this has actually kept a lid on 30 Year mortgage rates. I expect this to continue for a while until there is some real credible impetus for moving rates higher.

Are there more resources on this topic?

Plenty. I'll suggest two easy reads.

First, this recent op-ed on the topic by Neel Kashkari, the president of the Federal Reserve Bank of Minneapolis.

Second, Forbes has a good explainer on the topic as well.