One of the best predictors of future economic performance is the spread between the bond yields of different maturities. In simple terms, look at the difference between 10-year Treasuries and 2-year Treasuries, or 5-year Treasuries and 30-year treasuries.
Generally speaking, if the gap is rising, the yield curve is steepening. That’s a bullish sign for investors and the economy. If the gap is shrinking? Well, watch out.
The spread between the 2-year and 10-year US Treasury yields is at its lowest point since 2007, right before the financial crisis. The yield curve is flattening, which could be a sign that economic growth is slowing.
As the chart above shows, when the spread between the 2- and 10-year Treasuries narrows toward 0 percent, GDP growth slows a few quarters later. It happened in 2000-2001, as the yield curve actually inverted and the economy contracted. It happened in 2007, which preceded the Great Recession. The spread has narrowing for nearly 3 years, but is it now at a critical level?
Not only that, but the gap between the 2-year and 10-year US Treasuries has fallen for 8 straight days (as of November 8th – some of the daily changes in the chart below are negative, though near zero). What do investors see that is causing the yield curve so quickly?
The gap between the 2-year and 10-year yields is 0.68 percent. That’s worrying. But it’s not a guarantee of recession.
First, there really isn’t any catalyst to the flattening yield curve. If anything, things seem calmer than they were just a few months ago. The fire-and-fury Trump statements have subsided (especially while on the Asian continent). The VIX – or the market fear index – is still below 10. Corporate earnings have come in above expectations. Things seem to be humming along. The bond market alone seems to be flashing a signal that isn’t mirrored in the rest of the markets and the economy.
Second, there have been large foreign purchases of US Treasuries in recent months. According to Bloomberg, China purchased more US debt in August (the most recent month available) than any month since July 2016. More foreign inflows would likely suppress yields. If the purchases are heavily weighted in longer-term debt, that would cause the spread to narrow. Indeed, the 10-year yield has been relatively flat, while the 2-year has trended upward. Foreign investors might be buying enough longer-dated debt to keep those yields relatively low.
The Noisy Calm
There is no smoking gun here. The mechanics of the bond markets are obfuscating what is really happening. But perhaps that is the reason to worry. Bond investors are often called the smartest people in the markets. Things might not be as calm and complacent as we expect.