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We are in the presence of the dreaded flat yield curve. Now, I'm aware that the concept of a yield curve is very counter-intuitive, and many people find it a little intimidating. So let me quickly go through what we mean by a yield curve.
Now, in each of these charts, this axis is time. So we get further into the future as we go to the right. And this access is the interest rate. So interest rates go up, so that chart moves upwards.
Now, a normally shaped yield curve is like this. In other words, short-term interest rates are low, and then as you lend further into the future, rates go higher, obviously enough, because the risks are going to be greater if you're lending further into the future. Occasionally, however, you have more of a flat yield curve, which is what we have now when there is very little sense of differentiation in rates over time. And every so often, you have the dreaded inverted yield curve, when near term rates are actually higher than long-term rates, implying that people think the economy is going to slow down in future, and so rates are going to have to come down.
Now, if you take a look at the yield curve over the last 25 years, this shows you the gap between 10 and two-year yields in the US Treasury market. You can see there are only two periods in that whole quarter of a century when the yield curve has been inverted for any period of time. And they came before the two big financial crises and recessions - the dotcom burst followed by the recession of the early 2000s, and then, of course, before the great financial crisis and the Great Recession later in the 2000s.
Does that mean we should be worried that the yield curve is now as flat as it's been since early 2007? It's actually below 40 basis points for the first time since then, since we've heard from the Federal Reserve earlier this week. Now, arguably not. If you take a look at this period here in the late 90s, which is the era of the Clinton boom and of the great bull market in stocks that came before the dotcom bubble, you can see that the yield curve is pretty much as flat as it is now for several years. That didn't stop people making an awful lot of money in the stock markets and doing very well in the economy.
But I do think there is still reason for concern. If you take a look at the way the curve has moved in the last three or four years, there is an inexorable steady move downwards, a flattening of the curve. Ultimately, I think that is because the investors are still ultimately preoccupied by the Fed. If the yield curve is flattening, that means that you think that the Fed is more likely to make a hawkish mistake, raise rates too much in the near future, and then have to reverse course soon after. That, particularly after we heard from the Fed earlier this week, is why people are as worried as they are about a flat yield curve.