Some economists are starting to worry about the future of the economy, pointing to a “flattening” of the yield curve, or term spread as it’s also referred to, of the bond market.
The bond market is looked at as an indicator of economic health because of how government bonds are typically in sync with interest rates and the economy at large. While not discussed as routinely as the stock market (the bond market is decidedly less sexy than the stock market), it’s about twice the size of the stock market with far more trading activity. Because bonds generally follow economic activity, they can be predictive of the stock market. And the stock market is a lagging indicator of the economy; once stocks start falling, it’s too late, just as we saw with the 2007/2008 recession.
First, real quick, the basics. Let’s get real simple: what’s a bond and how does it work?
A bond is an investment product where “an investor loans money to an entity.” The entity, like a corporation or government, borrows the money for a set period of time at an interest rate that can be either variable or fixed. Investopedia explains that “bonds are used by companies, municipalities, states, and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors, of the issuer.”
There are short term bonds and long term bonds. Short term bonds (less than 5 years) are considered lower risk and thus pay lower interest, or yield. This is because short term bonds lock up your money for a shorter time. As such, longer term bonds (10 years +) carry greater risk for the investor and thus pay a higher interest rate, or yield. The risk of a long term bond is associated with the possibility of interest rates moving, as well as greater market forces, and affecting the bond’s price.
So what is a yield curve / term spread?
Simply put, the yield curve is the difference between interest rates of a short term bond and a long term bond. The New York Times recently explained that “typically, when an economy seems in good health, the rate on the longer-term bonds will be higher than short-term ones. The extra interest is to compensate, in part, for the risk that strong economic growth could set off a broad rise in prices, known as inflation. Lately, though, long-term bond yields have been stubbornly slow to rise — which suggests traders are concerned about long-term growth — even as the economy shows plenty of vitality.”
Analyzing the yield curve
A Forbes article from the beginning of the month put it like this: “When the difference between yield on shorter term government bonds and longer term government bonds is low, it can signal weaker growth in future years.” This is because a bigger gap, specifically a higher rate on long-term bonds, is directly correlated to strong economic growth that could set off a rise in prices, a.k.a. inflation, when there is greater economic demand and things become more expensive. This is a risk to the bond holders, but it’s also a good sign for the economy.
With the Federal Reserve raising short-term interest rates, the gap between the yields of short-term and long-term bonds has been flattening, or shrinking. Today, the gap is about 0.34 percentage points, according to The Times. They reported that the yield curve was last at levels like that in 2007 just before the onslaught of the recession.
If you’re keen to know more, check out the charts published by The New York Times, here.
