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.
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. 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.
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.
