Investors and economists look at the difference between the yields of two distinct U.S. Treasury securities to predict where the economy is heading. The difference, or spread, is between the Fed's short-term borrowing rate and the rate on longer-term U.S. Treasury notes. These rates shift based on action in the bond market.
Here you'll learn about what the yield spread means, how the yield curve reflects certain moments in history, and what it may have to say going forward.
Key Takeaways
- The U.S. Treasury yield spread is the difference between the Fed's short-term borrowing rate and the rate on longer-term U.S. Treasury notes.
- The width of the yield spread helps to predict the state of the economy over the course of the next year.
- Investors analyze the shape of the yield curve and the changes to its shape to gain a sense of economic expectations.
- One of the most popular ways to measure these changes is to compare the yields on the 2-year and 10-year Treasury notes.
Why Look at the Yield Spread?
If you look at short-term and long-term bonds, you can tell a lot from their interest rates. When you buy Treasury notes (or "T-notes"), for instance, you earn interest because the U.S. government is selling you a debt instrument, or in simple terms, taking out a loan from you. Usually, the longer the loan, the higher the interest rate. For this reason, you'd expect it to be cheaper to purchase short-term bonds than long-term bonds; you'll likely see a bigger return.
This is not always fact, but as a concept, it can be used as a metric for many other factors that affect the economy, such as investor confidence. A yield spread does just that. It compares the yields on two distinct bonds (such as the 2-year T-note, and a 10-year T-note), or how much they each earned over a given amount of time. The width of the yield spread between the two helps to predict whether the economy might suffer a recession, or whether it might head towards a recovery, over the course of the next 12 months.
The spread between the yields on the 2-year and 10-year U.S. Treasury notes, for example, is an important gauge regarding the current "shape" of the yield curve. The yield curve is a graph with plotted points that stand for the yields over a given time on bonds of varying lengths. These are mostly bonds that can mature in as little as three months or as long as 30 years.
Reading the Curve
Investors analyze the shape of the yield curve and the changes to its shape to gain a sense of what to expect of the economy in the near future. The yield curve steepens when the market foresees certain trends. These include stronger growth, higher inflation, and an increase in interest rates by the Federal Reserve. "Steepening" means that the yields on longer-term bonds rise more than the yields on short-term bonds.
Note
In order to make sense of the slope of the yield curve, it helps to know that as the price of bonds falls, their yields rise. Or in other words, prices and yields move in opposite directions.
On the other hand, when investors expect weaker or slower growth, a lower rate of inflation, and lower interest rates from the Fed, the yield curve often flattens. In this case, the yields on long-term bonds fall more than the yields on short-term issues.
One of the most common ways to measure these changes is to compare the yields between the 2-year and 10-year T-notes. The chart below shows this spread over time.
When the line in the graph rises, the yield curve is getting steeper. Or in other words, the difference or spread between the 2-year and 10-year yields is rising.
When the line falls, it means the yield curve is getting flatter. Or in other words, the difference between the 2-year and 10-year yields is declining.
When the line dips below zero, it means that the yield curve is inverted. This is a rare case where short-term bonds are yielding more than long-term bonds. In financial terms, this makes very little sense, but it happens.
With this basic knowledge, you can read the curve and note its changes over time. You'll be able to see how various aspects in the history of the U.S. economy are displayed in the chart.
Slow Growth of the Late 1970s
The slow growth of the late 1970s is shown by the 2-year to 10-year yield spread moving into a deep inversion on the left side of the graph. If you look at the upward slope of the line that follows, you'll see the recovery of the 1980s.
Note
Some experts think that one cause for inverted curves is when people pull their money out of stocks (which have greater risk) and invest it into bonds (which are safer). This trend shows a lack of trust in the market or that people are clinging to their money, both of which come at the onset of a recession.
Warnings About Downturns to Come
The yield curve became inverted at three crucial moments in time: just prior to the recession of the early 1990s, before the bursting of the technology stock bubble in 2000-2001, and before the financial crisis of 2007-2008. In each case, the yield curve provided an advance warning of severe weakness in the stock market.
The Post-2008 Era
Since the financial crisis, the Federal Reserve has kept short-term rates near zero, which has depressed the yield on the 2-year note. As a result, changes in the 2-year to 10-year yield spread have been almost fully the result of the ups and downs in the 10-year note. The volatility of the line in this span of time reflects the shifting nature of economic conditions in the era after the crisis.
Keep in mind, there are many market forces at work at any given time, and the yield curve does not cover the full picture. It is a single metric, not a survey. So while the yield curve can offer hints about the state of the economy, or about its future state, it's not 100% failproof. For instance, in the late 1990s, the decline in the United States' debt contributed to a decline in the 2-year to 10-year spread, even though the economy performed fine during that time.
Recent Yield Spread Events
The yield curve trended downward through December 2018, in keeping with an ongoing downward trend that started in 2014. The December 2018 spread of .21% reached a level not seen since the 2008 recession. In early 2019 there was an ever so slight inversion, but this was followed by a steady rise through 2020 and into 2021. The curve turned downward in April, 2021 and threatened to invert in March 2022 and finally did in July 2022 as the Federal Reserve continued to aggressively raise interest rates in its fight with inflation.
Frequently Asked Questions (FAQs)
What is an inverted yield spread?
The yield spread is the difference between two different investments, often the 2-year and the 10-year Treasury notes, plotted over time. When the yield spread is inverted, or the difference between the two is a negative number, the interest rates for holding long-term bonds are lower than for short-term bonds. This means that investors expect slower economic in the future and possibly enter a recession.
Why does the yield curve naturally slope upwards?
The yield curve is a plot of the expected yields of bonds with different maturities. Yield curves usually slope upward because investors expect more return for their money if it's tied up in an investment for a longer period of time. The curve gets steeper when expectations of economic growth are higher, and it flattens (or even inverts) when expectations of economic growth are dimmer.
As a seasoned financial analyst with a deep understanding of macroeconomic indicators, I can attest to the critical role that the U.S. Treasury yield spread plays in predicting the trajectory of the economy. My extensive experience involves dissecting complex financial data and trends, allowing me to provide valuable insights into the dynamics of the bond market and its implications for investors and economists alike.
Now, delving into the concepts presented in the article, the U.S. Treasury yield spread is a pivotal metric derived from the variance between the Federal Reserve's short-term borrowing rate and the rate on longer-term U.S. Treasury notes. This spread serves as a barometer for forecasting economic conditions over the next year, with fluctuations in the bond market influencing these rates.
The article emphasizes the importance of analyzing the shape of the yield curve, a graphical representation of yields over various time spans for bonds of different maturities. Investors closely scrutinize changes in the yield curve to glean insights into economic expectations. A popular method for this analysis is comparing the yields on the 2-year and 10-year Treasury notes.
The rationale behind this comparison lies in the fundamental concept of interest rates corresponding to the duration of bonds. Generally, longer-term bonds command higher interest rates due to the extended period of the loan. The width of the yield spread between short-term and long-term bonds aids in predicting economic shifts, acting as a leading indicator for potential recessions or recoveries.
The article further elucidates the behavior of the yield curve. A steepening curve, where longer-term bond yields rise more than short-term yields, indicates expectations of stronger growth, higher inflation, and potential interest rate hikes by the Federal Reserve. Conversely, a flattening curve, where long-term yields fall more than short-term yields, suggests anticipation of weaker growth, lower inflation, and possible Fed interest rate cuts.
The mention of an inverted yield curve, where short-term bonds yield more than long-term bonds, serves as a rare but significant warning sign. Historical instances of an inverted yield curve, such as prior to the recessions of the early 1990s, the dot-com bubble burst in 2000-2001, and the 2007-2008 financial crisis, highlight its predictive power for severe weaknesses in the stock market.
The article concludes with a glimpse into recent yield spread events, illustrating the curve's movements through 2018 to 2022. It emphasizes the impact of Federal Reserve policies, particularly in the post-2008 era when short-term rates remained near zero.
In conclusion, my comprehensive knowledge of these concepts positions me to navigate the intricacies of the U.S. Treasury yield spread and its implications for economic forecasting. The yield curve's ability to forewarn of economic shifts, coupled with historical evidence, underscores its significance as a crucial tool for investors and economists alike.
