Yield Curve

The media has been in a frenzy again about the yield curve, a leading indicator for recessions. The yield curve is the difference between the yields of U.S. Treasury securities that vary by their term length. The term length is the amount of time you’d have to hold the security for it to fully mature and Treasury securities are issued for numerous terms. For example, if the 10-Year Treasury Constant Maturity Rate is 2.44% and the 2-Year Treasury Constant Maturity Rate is 2.31% then you get an extra 0.13% for holding the note for 10 years rather than 2.

The yield curve is made up of the spread in the rates of Treasury securities for different terms. Taking the example above, the spread between the 10-year and 2-year securities is the spread between is 0.13%. We could also calculate the spread between the 30-year and 20-year, or 30-year and 10-year, etc. In this post I’ll be using the spread between the 10-year and 2-year securities and 10-year and 3-month securities.

The yield curve is interesting because sometimes it “inverts”. That is, sometimes the rate for a longer term security is lower than that for a shorter term security. The reason this is so interesting is because investors want to be compensated for taking on greater risk (e.g. holding the security for 10 years) and therefore riskier investments should have higher yields. But in some cases the shorter termed security has the better rate.

Here is a plot of the yield curve, showing the 10-year minus 2-year and 10-year minus 3-month spreads, with recessions, according to the National Bureau of Economic Research (NBER), in gray. Note that data for the 3-month securities is not available as far back as for the 10-year and 2-year securities.

The yield curve is considered a leading indicator of recessions because it sustained an invertion before each of the recessions. For example the 10-year minus 2-year spread was inverted throughout 2006 and 2007 prior to the 2008 financial crisis.

Both the 10-year minus 2-year and 10-year minus 3-month spreads have high positive autocorrelation at 12-months (0.98 and 0.98), meaning that these timeseries are strongly associated with themselves (i.e. similar) at any given point compared to 12-months before or after.

Interestingly in at least the past 3 or 4 recessions, the yield curve had already reached its lowest point and begun to rebound by the time the economy entered a recession. For example look at the 2008 recession.

At this point (April 2019) the yield curve has been steadily declining since 2014 but hasn’t yet reached a monthly average below the inversion point.

In 2014 the stock market returned to its pre-2008 value (as measured by the S&P 500 and the Federal Reserve stopped purchasing new securities as part of quantitative easing. Quantitative easing may have helped boost rates and the stopping of those security purchases may have contributed to the narrowing of the spread between security yields. The Fed didn’t start to reduce their holdings until the end of 2017.