Key Points

  • The yield curve has been flattening and the 10s-2s spread hit a low of 41 basis points last week, raising concerns.

  • Although ample headlines have warned about imminent threats of an inversion and subsequent recession, history shows long lag times and healthy stock market performance.

  • Large caps could resume their outperformance if yield curve history is any guide.

The spread between the 10-year Treasury and 2-year Treasury yields has narrowed to below 50 basis points, with countless media headlines raising alarm bells and warning about an impending inverted yield curve and possible subsequent recession.

First a primer

The yield curve is a graphical plot of the yields of bonds with different maturities; and the aforementioned “10s-2s” spread is one of the more commonly-tracked. In a normal economic/market environment, the curve is generally upward-sloping as yields on longer-term bonds are typically higher than shorter-term bonds, because the former are higher-risk investments due to their duration.

An inverted yield curve occurs when shorter-term rates are above longer-term rates. This happens when the Fed hikes the fed funds rate to beyond the yield of longer-term Treasury securities; and has been a fairly accurate recession signal historically, albeit with a lag.

What say you Fed?

The topic has become a hot one at client events at which I’ve spoken recently. Investors are worried. But want to know who are, for the most part, not worried? Federal Reserve (Fed) officials:

  • Philadelphia Fed’s Pat Harker (and my friend and former President of my undergraduate alma mater, University of Delaware): “I’m also keeping an eye on the yield curve. I think worries so far have been a little inflated.”
  • New York Fed’s William Dudley: “I am not concerned about the recent flattening of the Treasury yield curve.”
  • Chicago Fed’s Charles Evans: “Yield curve not nearly as much of a concern as I might have pointed to a couple of months ago.”
  • San Francisco Fed’s John Williams: “The flattening of the yield curve that we’ve seen is so far a normal part of the process, as the Fed is raising interest rates, long rates have gone up somewhat—but it’s totally normal that the yield curve gets flatter.”
  • Cleveland Fed’s Loretta Mester: “I just think long rates are going to go up given where we are in the economy and given where we see the economy going. But this is another reason why we need to keep raising up the short rate.”
  • Fed Vice Chair for Supervision Randal Quarles: “I’m not viewing the current flattening of the yield curve as much of a signal toward an impending recession.”