Why investors should pay attention to flattening yield curve

Lately, I’ve been reading and hearing more about the yield curve which is not so curved any more. Instead, it is beginning to become rather straight or flat.

Some economists and investors are becoming worried the change in its shape may indicate a recession is on the horizon. These concerns may be wellfounded since a flattening yield curve has been a fairly reliable leading indicator of a slowing economy in the past. On the other hand, by many measures, today’s economy is the strongest it has been in years. I am thinking that things may be a little different this time, and the yield curve will not be the reliable indicator that it has been.

The yield curve is simply a curve that is made by connecting the dots on a graph that show interest rates of short, intermediate and long-term bonds given their respective maturities. On the Y-axis of the graph are yields and on the Xaxis of the graph are maturities. In a normal economy, long-term bonds pay more than short-term bonds to compensate for the risks of holding a fixed-rate investment over an extended period of time.

The respective yield curve, moving from left to right on the graph, will rise showing that long-term bonds are paying more than short-term bonds. A flat yield curve means that, regardless of the maturity of a bond, the interest rate received is the same. An inverted yield curve is rather rare. This occurs when short-term bonds pay a higher rate of interest than longterm bonds. Again, when moving from left to right on a graph, a normal yield curve moves higher, a flat yield curve is flat, and an inverted yield curves moves lower.

So why the worries about a flattening yield curve? If it becomes flat, it would show that bond investors are willing to buy long-term maturities that pay the same interest rate as short-term bonds. Why would they do that? One of the main reasons would be these investors believe the economy is going to decline and that the return of other assets, such as the stock market and bond yields, will also fall. Therefore, the logic is to lock in lower yields on long-term bonds rather than higher yields on shorterterm bonds.

To that point, bond traders will often claim they are smarter than stock traders. That is a pretty braggadocio claim which can be debated. What I do know, however, having been in the investment business for over 30 years, is the bond guys are a pretty smart bunch and it is wise to pay attention to what is happening in bond land.

Although the yield curve has been a well-regarded indicator of economic growth, inflation and recession, the flattening of it may not have predictive power of the past. One reason is the Fed has been aggressively raising shortterm interest rates. That will not last forever, but the action does have an immediate flattening affect. Also, many of the central banks across the world have been working to push down long-term rates in their respective economies. As a result, foreign investors are opting to buy long-term bonds in the United States rather than in their home countries. Arguably, these foreign investments indicate a vote of confidence in the United States.

In today’s economy, the forecasting ability of the yield curve might be less dependable than it has been in the past. Nonetheless, it is something to which you want to pay attention, as you invest for your future.

This article was written by Ken Levy, a certified financial planner professional and a principal with Levy, Daniel & McGee Wealth Management. Wells Fargo Advisors Financial Network is not a legal or tax advisor. Levy, Daniel & McGee Wealth Management is a separate entity from WFAFN.