​The Autumn for Yield Spreads

As we move into the Fall Season, let’s take note of something else that’s falling besides leaves. Yield spreads (specifically, the difference between 2 Year and 10 Year US Treasury yields) have been falling consistently since late 2013, when the 2-10 Year US Treasury yield spread peaked at 266 bps. Today, it’s 83 bps (see Chart) – that’s a 70% tightening or flattening of the yield curve.

The Federal Reserve affirmed this week their intentions to begin in earnest the reversal of the historically massive quantitative easing that has resulted in more than $4 trillion in US Treasuries on their balance sheet. Fed officials are projecting one more rate hike this year, and then three more next year, but market participants have much to wonder about how rising rates will play out.

As seen in the above chart, since the mid-1970s, whenever there was a negative yield curve spread (aka, an inverted yield curve – where short-term debt yields are higher than long-term yields) a recession had followed (the gray shaded areas are recessions). We’re now approaching levels of yield compression not seen since November 2007, nearly a decade ago. Though still a positive spread number for now, the trend is a deteriorating one. And, this is before the Fed has officially acted to reverse its near decade long course.

The Fed is certainly keeping a close eye on yield spreads. Particularly, FOMC actions primarily effect the shorter-end of the yield curve, not long-dated maturities. As monetary tightening occurs through Fed activity on short-dated debt, near-term rates are at risk of going higher more quickly than long-term rates. The Fed has not articulated how they plan on managing this risk. They haven’t, because they can’t.

For the sake of all that is good in our current late stage economic growth cycle, I hope that my worst fears will not be realized, and that by some magical market force, short-term rates will stay lower than long-dated debt. But, decades of history show us a lesson that clearly cannot be learned.

The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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