Photo: Billy Hathorn; Source: Wikipedia
130 years ago the English schoolmaster Edwin Abbot wrote the novella “Flatland” about a two-dimensional world inhabited by geometric shapes. There’s no depth in Flatland, only height and width.
It seems like investors today are entering a “flatland” of their own. Normally, long-term bonds yield significantly more than short-term bonds. We call this the “yield curve,” because it curves downwards. A year ago, 10-year US Treasury bonds yielded almost 2% more than 3-month Treasury Bills. Now, they only yield 1% more. In other words, the “yield curve” has flattened.
Sometimes, a flatter yield curve can signal slower economic growth. Before each of the last three recessions, the yield curve – as measured by the difference between 3-year and 10-year US Treasury Notes – inverted. That is, the 3-year note yielded more than the 10-year Note. Investors were so worried about a slowing economy and falling interest rates that they were willing to put up with a lower long-term yield, even though that exposes them to more volatile bond prices.
Source: Federal Reserve
The yield curve usually flattens when the Fed raises interest rates, as they have been lately. The curve inverted in 1989, 2000, and 2006. Those were good times to be careful. The ensuing recessions were vicious, both economically and in the equity markets.
Should investors be worried now? After all, the yield curve is flatter than now it was last year, and the year before that. But the curve has been much flatter than this in prior years, most notably in the late 1990s, when the economy boomed and the stock market more than doubled. Bond market investors were cautious, but other factors indicated that the economy could keep moving forward.
One of the most difficult aspects of investing is “recency bias” – the sense that the times we live in are normative, and trends will continue in the future the way they’ve been going in the past. In the same way, the inhabitants of “Flatland” couldn’t imagine a world with three dimensions. But the lessons of history are that times can change.
Our flattening yield curve isn’t signaling an imminent threat to the economy – at least, not yet.
Douglas R. Tengdin, CFA