You may have heard commentators recently concerned about the flattening of the yield curve. The yield curve is the Treasury rate's yield on short- to long-term Treasury bonds, as represented on a chart. Typically, short-term Treasury bonds demand lower-rate yields than longer-term Treasury bonds. But what does all of this have to do with a recession? Here's an in-depth explanation — and reasoning on why it may not be cause for concern.
When placed on a chart from short-term to long-term bond rates, the curve is upward swinging. This makes good sense: If you wanted to loan someone money for one month, you would ask for a lower interest rate because you could get your principal back in one month. But if you wanted to loan your money to someone for 10 years, you would expect a higher interest rate because you would not have access to your money for a decade. Simply put, more liquidity is always better than less liquidity; therefore, people are typically willing to receive a lower interest rate in exchange for the luxury of having access to their money sooner rather than later.
A flat yield curve indicates that those with money to loan are willing to get the same interest rate to loan their money short-term as they would if they loaned their money long-term. An inverted yield curve means that people will accept a lower interest rate for loaning money for a longer term. That's counterintuitive — but why are so many commentators worried about it?
Historically, a flattening or inverted yield curve proceeds a recession. Why is that? A flat yield curve states that those who have money to loan are worried that loaning their money in the future will carry a lower interest rate, so they decide to loan their money today to lock in a higher rate for a longer period of time. Generally, when money lenders start to believe that there will be less demand for borrowing in the future, they loan money at a lower interest rate to increase demand.
If there is going to be a recession, fewer people will want to borrow money because there is less economic activity, which means there's less need to borrow and therefore lower demand. That's why a flattening or inverted yield curve predicts a recession — money lenders see it in the future. Of course, this assumes that markets are always correct in predicting the future and that markets always operate efficiently.
But here could also be a different explanation for a flatting or inverted yield curve, one that's unrelated to a future recession. Even though markets, in general, operate efficiently, there is another factor that affects interest rates that is not market-based: the Federal Reserve. It's tasked with maintaining monetary policy for the United States, and one of the tools at its disposal is manipulating monetary policy via the federal funds rate, which is the rate set by the Federal Reserve for overnight loans between lending institutions.
The fed fund rate affects short-term rates directly, but it has little effect on longer-term rates. Therefore, when the Federal Reserve increases the fed fund rate, short-term Treasuries are directly affected and follow in lockstep. However, long-term rates, such as the ten-year Treasury rate, operate with different mechanics. Historically, the largest investors in Treasuries were limited to money lenders within the U.S. But with globalization came a more diverse group of investors who operate under different incentives for investments in U.S. Treasuries.
That means that global geopolitical or economic instability affects the ten-year rate. As world markets become unstable, money from around the world flows into the safest investment vehicle (long-term Treasuries), causing rates to fall.
Another important factor affecting long-term treasury rates is the recent rise of third-world countries. In the past decade, countries such as China have seen immense growth in private wealth. Where there is wealth, there is the desire to put that wealth in safe assets such as long-term Treasuries. This large amount of additional wealth created by globalization has greatly increased the demand for U.S. Treasuries.
These additional factors cause long-term rates to remain fairly stable, and the excess demand for safe assets is a dampening factor that keeps long-term rates low and fairly stable. Therefore, you can see that short-term rates are directly affected by actions of the Federal Reserve, while long-term rates are directly impacted by market forces. As the Fed has steadily increased the fed funds rate, the short-term rates have moved higher to reflect those increases. But since it has little effect on the long-term rates, and the other factors that contribute to the long-term rates have remained stable, those rates remain largely unchanged.
In short, long-term rates have stayed the same, while short-term rates have risen. When you hear commentators mentioning the yield curve, remember that a flattening or inverted yield curve has more to do with an artificial increase in the short-term rate than with market perception of a future recession.