Flattening Yield Curve and Gold

Flattening Yield Curve

If you have been listening to the Cable Financial News Networks of late, you have likely heard them talking a lot about the flattening yield curve.

So what are they referring to?

A yield curve is explained as the yield of each bond along its maturity that’s plotted on a graph. It indicates a visual image of long term versus short-term bonds at various points in time.

The yield curve normally slopes upward as investors expect to be compensated with higher yields for assuming the added risk of investing in longer term bonds. (Remember rising bond yields reflect falling prices and vice- versa.)

A flat yield curve indicates that little, if any, difference exists between short-term and long-term rates for bonds and notes of similar quality.

The general direction of the yield curve in a given interest-rate environment is typically measured by comparing the yields on two- and 10-year issues, but the difference between the Fed Funds rate and the 10-year note are often used as well.

The understanding of a flattening yield curve is pretty straightforward. The yield curve flattens when the difference between yields on short-term bonds and yields on long-term bonds decreases.

A flattening yield curve can indicate that expectations for future inflation are falling. Investors demand
higher long-term rates to make up for the lost value because inflation reduces the future value of their investments.

The premium declines when inflation is less of a concern. A flattening yield curve can also occur in anticipation of slower economic growth. Sometimes the curve flattens when short-term rates rise on the expectation that the Federal Reserve will raise interest rates.

On the rare occasions when a yield curve flattens to the point that short-term rates are higher than long-term rates, the curve is said to be “inverted.” Historically, an inverted curve often precedes a period of recession. Investors will tolerate low rates now if they believe that rates are going to fall even lower in the future.

On Friday the spread between 2-year note and 10-year note tightest since August 2007.

The yield gap between the 2-year and the 10-year note narrowed to 21.1 basis points, its tightest since August 2007. A flattening yield curve, reflected in a narrowing spread between short-term maturities and their long-term maturities, can signal growth fears, but also expectations for tighter monetary policy.

This morning the gap between the 2 year treasury and 10 year Treasury Bond has come in further, now at 18 basis points. The question now is are we headed to an inverted yield curve? Which in the past has indicated a rescission is coming.

This is something that needs to be watched very closely .

I’m not claiming the sky is falling, but historically Treasury Yield curves inverted just before recessions in 1981, 1991 and in the year 2000.

So let’s define an inverted yield curve, because there is a possibility that the 2 year and the 10 year treasuries will continue to narrow.

An inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. In a normal yield curve, the short-term bills yield less than the long-term bonds. Investors expect a lower return when their money is tied up for a shorter period of time. They require a higher yield to give them more return on a long-term investment.

When a yield curve inverts, it’s because investors have little confidence in the near-term economy. They are demanding more yield for a short-term investment than for a long-term one. They would prefer to buy long-term bonds and tie up their money for ten years even though they receive lower yields. They would only do this if they think the economy is getting worse in the near-term. An inverted curve can predict a recession.

An inverted yield curve is most obvious with Treasury note yields. That’s when yields on one-month, six-month, or one-year Treasury bills are higher than yields on 10-year or 30-year Treasury bonds. During healthy economic growth, the yield on a 30-year bond will be about
three points higher than a three-month bill.

In an inverted yield curve investors believe they will make more by holding onto the longer-term bond than if they bought a short-term Treasury bill.

They’d just have to turn around and reinvest that money in another bill. If they believe a recession is coming, they expect the value of the short-term bills to plummet sometime in the next year. They know that the Federal Reserve lowers the Fed Funds Rate when economic growth slows. Short-term Treasury bill yields track the fed funds rate.

So why does the yield curve invert? As investors flock to long-term Treasury bonds, the yield on those bonds fall. They are in demand, so they don’t need as high a yield to attract investors. The demand for short-term Treasury bills falls. They need to pay a higher yield to attract investors. Eventually, the yield on short-term bills rises higher than the yield on long-term bonds and the yield curve inverts.

Recessions last 18 months on average. If investors believe a recession is imminent, they’ll want a safe investment for two years. They’ll avoid any Treasuries less than two years. That sends demand for those bills down, sending yields up, and inverting the curve.

As I indicated before, the Treasury yield curve inverted before the recessions of 2000, 1991, and 1981.

The yield curve also predicted the 2008 financial crisis two years earlier. The first inversion occurred on December 22, 2005. The Fed, worried about an asset bubble the housing market, and had been raising the fed funds rate since June 2004. By December, it was 4.25 percent. That pushed the yield on the two-year Treasury bill to 4.40 percent. But the yield on the seven-year Treasury note didn’t rise as fast, hitting only 4.39 percent. That meant investors were willing to accept a lower return for lending their money for seven years than for two years. That was the first inversion.

By December 30, the discrepancy was worse. The two-year Treasury bill returned 4.41 percent, but the seven-year note yield fell to 4.36 percent. The 10 year treasury note yield dropped to 4.39 percent, below the yield for the two-year bill. A month later, on January 31, 2000, the Fed had raised the fed funds rate.
The two-year bill yield rose to 4.54 percent. But that was more than the seven-year yield of 4.49 percent. Yet the Fed kept raising rates, hitting 5.25 percent in June 2006. Looking at the fed fund rate history can give you an idea on how the Federal Reserve has managed inflation and recessions throughout the years.

On July 17, 2006, the inversion worsened again when the 10-year note yielded 5.07 percent, less than the three-month bill at 5.11 percent. This showed that investors thought the Fed was headed in the wrong direction. There are many articles written that describe how Subprime mortgage defaults caused the 2007 banking crisis, which led to the 2008 financial crisis and the worst recession since the Great Depression.

Unfortunately, the Fed ignored the warning. It thought that as long as long-term yields were low they would provide enough liquidly in the economy to prevent a recession.

The Fed was dead wrong.

The yield curve stayed inverted until June 2007. Throughout the summer, it flip-flopped back and forth, between an inverted and flat yield curve. By September 2007, the Fed finally became concerned. It lowered the fed funds rate to 4.75 percent. It was a 1/2 point, which was a significant drop. The Fed meant to send an aggressive signal to the markets. The Fed continued to lower the rate 10 times until it reached zero by the end of 2008. The yield curve was no longer inverted, but it was too late. The economy had entered the worst recession since the great depression.

I don’t know for sure what this indicates. Most of us believe that the economy is in good shape, as we witness almost every day the stock markets setting new highs. Also setting new all-time highs are individual household debt, U.S. Debt and runaway government spending, which is a very big concern. So some will argue that all is well. But some will argue because of the enormous debt we are currently holding the economy is hanging on by a thread at the same time.

Maybe the tightened yield curve reflects the fact that no one knows what to think. One thing is for sure, there are two very different opinions on where we are headed.

What do you believe?

If you believe in the latter, an investment in physical Gold could be a wise choice.

Have a wonderful Monday.

Disclaimer: This editorial has been prepared by Walter Pehowich of Dillon Gage Metals for information and thought-provoking purposes only and does not purport to predict or forecast actual results. This editorial opinion is not to be construed as investment advice or as a recommendation regarding any particular security, commodity or course of action. Opinions expressed herein cannot be attributable to Dillon Gage. Reasonable people may disagree about the events discussed or opinions expressed herein. In the event any of the assumptions used herein do not come to fruition, results are likely to vary substantially. It is not a solicitation or advice to make any exchange in commodities, securities or other financial instruments. No part of this editorial may be reproduced in any manner, in whole or in part, without the prior written permission of Dillon Gage Metals. Dillon Gage Metals shall not have any liability for any damages of any kind whatsoever relating to this editorial. You should consult your advisers with respect to these areas. By posting this editorial, you acknowledge, understand and accept this disclaimer.