The bond market’s yield curve has flattened sharply in recent months, pushing closer towards inverted territory, leaving many investors increasingly concerned about what will happen next.

The shape and slope of the yield curve, which plots the interest rates offered by bonds with the same credit quality but different maturity dates, is widely seen as a barometer of the future state of the economy, offering potential insights into what investors believe is going to happen with interest rates.

Historically, an inverted yield curve has generally been a good indicator that a recession will appear some 12 to 18 months later.

In practice, it is essential to look at yield curves on an individual currency basis, as there is no such thing as a global yield curve. The optical impression that global bond indices give of short-term rates being higher than long-term rates is the result of how these indices are constructed. In a typical global government bond index, the US accounts for around 50% of the market value at the short end of the curve (where US rates are higher) while non-US issues account for the bulk of longer-dated bonds in the index (where yields are lower). The reality is that yields should be compared in a single currency. In that case, in aggregate, global short-term rates remain lower than global long-term rates. While the global expansion might be mature, it is hard to say that global bond yield curves are predicting an imminent recession.

In the US, recent interest rate rises from the Federal Reserve (Fed) have contributed to the significant flattening of the US yield curve. However, the US yield curve has not yet inverted and yield curves elsewhere are still positively sloped as a result of the lack of monetary tightening. Additionally there is likely to still be some quantitative easing (QE) effect on the shape of the curve given the large amount of treasuries that the Fed holds on its balance sheet.

Where do the yield curve’s predictive powers come from?

When a single-currency yield curve has a ‘normal’ shape, it indicates that the yields offered by short-dated bonds are lower than those offered by long-dated bonds, and the curve has a slightly skewed concave shape.

This makes sense because one would expect investors to demand higher compensation for putting their money at risk for 20 years than they would for risking it only for a year. This is especially the case if they believe the economy is largely going to do well over time and inflation will increase, as they will then demand compensation to offset inflation’s erosive impact. This compensation for putting money away for longer is often referred to as the ‘term premium’.

The yield curve plots the relationship between the yield and expected time horizon of a bond

A ‘normal’ yield curve:

When investors have a less sanguine view of the economy, their view of the future changes and, with it, the shape and slope of the bond yield curve. If investors believe the economy is going to slow down, the expectation is that interest rates will decline over time in order to help revive growth. Accordingly, long-term investors look to lock into the higher interest rates on offer, before yields decline. This leads to greater demand for long-dated as opposed to short-dated bonds and consequently yields on long-dated bonds fall below those of shorter-dated instruments, as can be seen in the graph below.

An inverted yield curve:

Therefore, an inverted yield curve has been a reliable predictor of a coming recession. In fact, the spread between three month US paper and 10-year treasuries has inverted before each of the past seven recessions – including the last one which began in 2008.

Since then, however, central banks the world over have embarked on the largest monetary policy experiment in history, in the form of unprecedented asset purchase programmes and interest rate cuts. This has changed the global financial landscape and left a few question marks over many traditional relationships, including the recession-predicting powers of the yield curve.

Debt and quantitative easing play a major role

The flood of ultra-accommodative monetary policy that has characterised the past 10 years has pushed yields across the curve to historic lows and, in some cases, into negative territory. But in 2017, the global economy seemed to pick itself up off the floor. Sentiment rose, as did corporate earnings, and developed country central banks began turning their attention to unwinding some of this liquidity. Due to this shift in sentiment, yields rose.

Nevertheless, while the economy has improved markedly, inflation remains stubbornly low. So even as the Fed is increasing short-term interest rates, the lack of inflation has meant that investors have continued to remain buyers of long-term debt, which has helped support prices and, thus, keep a lid on yields. This has been exacerbated by the ongoing demand for long-term debt from central banks and insurance companies charged with ensuring that their assets match their liabilities.

The result has been an ongoing flattening of the curve but not for the reasons that have characterised the move in previous instances.

The other factor that has affected the relationship between the yield curve and the economy is the stock of debt currently sitting on global balance sheets.

One of the goals of QE was to induce companies to borrow money to invest that would in turn would help revive the struggling global economy – and in that sense, the policy has succeeded. But a side-effect is that debt levels across the world have ratcheted sharply higher. This is fine if borrowing costs remain cheap. However, government bond yields set the benchmark for borrowing costs and if they continue to rise, those companies and countries battling to meet their debts will struggle, which in turn could hit economic growth.

While these factors, and the ever present wild card that is the current geopolitical environment, make it harder than ever to predict what is likely to happen in the future, the yield curve remains a major port of call for investors assessing financial markets – and this doesn’t look likely to change anytime soon.