Flattening Yield Curve is Good
The post below is from our friend Axel Merk from Merk Investments. We have been talking about rising yields but still a flattening of the yield curve. Axel breaks down what it all means and more importantly what we should be watching in terms of the steepness and economy.
Click here to visit the Merk Investments website.
…Here’s the post…
In recent months, pundits have cautioned about a flattening yield curve, suggesting it may signal the end of the economic expansion, the end of the bull market, possibly even the end of the world as we know it. There’s plenty to worry about in the markets, but in the spirit that knowledge is the enemy of ignorance, let’s clear up some myths.
First, what is yield curve steepness? It reflects the relationship between the short end and long end of the yield curve. Got it? Okay, let’s dissect this jargon:
The “short end” of the yield curve refers to shorter-term interest rates. This could be the current Federal Funds Target that the Federal Reserve Open Market Committee (FOMC) controls and is colloquially referred to as the current interest rate; more broadly, it is referring to yields on Treasury securities of a few years. In the context of our discussion, many refer to 2 years or 3 years (although some go out as far as 5 years).
The “long end” of the yield curve refers to longer-term interest rates. This is often the yield on the 10-year Treasury bond, sometimes the 30-year Treasury bond (also called the “long bond”).
For some context, before the financial crisis, it was generally believed the Fed controls the short-end of the yield curve, whereas the long-end of the yield curve is more of a reflection of the longer run potential of the economy and longer run inflation expectations. Since the financial crisis, there’s a plethora of opinions to what extent the Fed’s quantitative easing (QE) has influenced longer-term rates.
The steepness of the yield curve is the difference between the yield at the long end of the yield curve and the short end of the yield curve. The 2s10s yield curve, for example, is the yield of the 10-year bond minus 2-year Treasuries plotted across time.
The yield curve is steep when short-term rates are lower than long-term rates; it is “flat” when they are the same; and the yield curve is inverted when short-term rates are higher than long-term rates.
In a classic banking model, banks borrow money short-term to make long-term loans. As such, when the yield curve is steep, the more money banks lend, the more money they make (assuming their borrowers don’t default); as the yield curve flattens and potentially inverts, margins could get squeezed and potentially become negative. It’s a tad more complicated than that because private borrowers pay a higher rate than that available to the government. An inverted yield curve may suggest that the Federal Reserve wants to slow the economy down.
With this context, please look at the chart …read more
Source:: The Korelin Economics Report