The Flattening Yield Curve Explained

If this trend continues, how might it impact risk and financial management in the coming business cycle?

In recent months, the trend on interest rates has moved ever-closer toward a U.S. Treasury yield curve inversion—creating concern among investors and money managers. When the yield curve inverts, this typically signals that investors expect the economy won’t be doing as well in the future, indicating a recession may be on the horizon. But what challenges and opportunities might an inverted yield curve bring for risk and capital management executives?

If the curve actually inverts, the risks presented can affect how your business raises capital, funds expansion and manages liquidity. Studying the curve can shed light on where we might be in the current economic cycle and aide in planning for potential volatility, slowed growth and even economic downturns. Considering these risks ahead of time means you may be able to capitalize on other opportunities and develop contingencies for economic limitations.

The Downside Risks

Tightened Lending

A yield curve visually represents how much it costs to borrow money for different periods of time. Banks typically engage in maturity transformation, relying on a favorable difference in rates to finance their longer-term lending with short-term deposits. The steepness or slope of the curve can correlate broadly with net interest margin.

Fixed-rate loans for industries such as commercial real estate may be priced off the corresponding Treasury rates, such as the 5-year or 10-year Treasuries. When the curve flattens—indicating that the rates are coming closer together – or inverts, banks may cut back on lending as well as seek to refinance their longer-term fixed loans at higher interest rates. New short-term loans may even be priced more expensively than new longer-term loans, and floating rate loans may exceed the coupon rate of what a fixed-rate loan would be.

Interest Rate Increases

The Federal Reserve Open Market Committee (FOMC) sets short term rates and can wield some influence further into the curve with quantitative easing (QE) measures. The long-end of the curve, however, is more directly forged by market expectations for inflation, economic growth, fiscal stimulus, and risk management. If the FOMC raises the federal funds rate in the near-term or inflation goes down, it may put downward pressure on the curve, possibly flattening or even inverting it.

Reduced Liquidity

The slope or expectations regarding the changing slope of the yield curve can put pressure on outstanding bond prices. Not all bonds carry the same degree of interest-rate risk; however, an increase in interest rates after a bond is purchased may likely result in a capital loss if the bond is sold prior to maturity date. As investors expect longer-maturity bond yields to fall, they might flock to purchase longer-maturity bonds to lock in yields before they decrease further. This may cause a dumping of short-term notes in favor of long-term debt and can, in turn, affect market liquidity—further flattening the yield curve or pushing it toward inversion.

Reduced GDP

A steepening (upward) yield curve typically indicates that the market anticipates rising inflation and stronger economic growth. Responses to a flattening curve can amplify conditions and lead towards inversion. If, for example, the market expects businesses to experience falling cash flows, stock prices may be impacted long before economic distress becomes a reality, as observed in December 2018.

Concerns about rates, lending, and liquidity along with the specter of weakening fiscal stimulus can increase investor fear that the economy might slow down and ultimately enter a recession. Historically, this has happened within two years or less of a curve inversion.

Will History Repeat Itself?

The curves between US three-year and five-year Treasury notes and two-year and five-year notes raised concerns when they inverted in December 2018. It was the first time that inversion had been observed since the yield for the three-year bond became higher than the five-year one in August 2005. The last inversions between the 2-year and 10-year Treasuries were in 2006 and 2007.

The St. Louis Fed noted that while the yield curve inversions can happen on average 10 months before a recession, “false positives have also occurred with the yield curve, such as the one that occurred in 1966.” Some analysts argue that the curve is distorted by the Fed’s intervention in the 2008 financial crisis. In other words, the effects of QE linger in the long-end of the curve, possibly making it less reliable than in the past as an indicator of economic downturn.

There are other distinct differences in the current cycle that provide a solid argument for why, even if the inverted yield curve continues to sharpen, the start of a recession might not be in the near future. For example, emerging market currency sell-offs and international trade policy struggles may increase demand for the US dollar—which in turn affects short-term rates.

Don’t Panic: Prepare

There are specific measures financial decision makers can take to define business capacity for risk and develop alternative options. When managing risk and capital, consider developing alternatives in the event that lending and liquidity challenges surface.

Companies needing flexibility, for example, may explore how short-term floating rate debt can better suit their capital management strategies. If hedging risk with alternative investments, pay close attention to how underlying assets could be affected by a flattening or inverting curve as well as any related factors.

Other factors to keep an eye on are how critical business partnerships could be impacted. Prioritize supply chain visibility to promptly identify any concerns that might arise from fallout such as tightened credit. Consider opportunities to deploy or invest capital in foreign markets as these investments/relationships may be impacted differently or not at all.

Forming a Partnership

The yield curve is inherently useful, but it is only one instrument in a diverse tool set. Your relationship manager can help you make analytical, informed decisions based on the financing needs of your organization and the indicators you have at your disposal. A few possible topics to discuss would be:

• Deciding whether to issue stock/commercial paper or take on debt (often in the form of corporate bonds) for financing needs
• Monitor existing debt and equity stakes
• Defining risk management and hedging measures (with swaps or other alternative investments)
• Directing how to do business with other business/industries that could be affected

Treasurers, CFO, and corporate finance executives may want to work closely with their banking relationship manager to learn more about how potential risk appetite changes in the market can affect risk and capital management practices.