Flattening of the yield curve may be hazardous to your financial health.

That is the warning being shouted from Wall Street this summer, and for many investors it raises the question: “What exactly is the yield curve anyway?”

Simply put, the yield curve is an illustration showing the difference between short- and long-term interest rates. It usually references yields on bonds issued by the U.S. government, called Treasuries. The 10-year Treasury is a commonly cited benchmark, its day-to-day movements considered a proxy for the bond market.

Normally, longer-term bonds pay investors more interest than short-term bonds to offset the effects of inflation. This produces a yield curve that slopes upward from left to right. Recently, however, the yield curve has “flattened.”

Action from the Federal Reserve has driven short-term interest rates higher, but long-term rates have hardly budged. The current gap between two-year and 10-year Treasury bond yields has shrunk to roughly 0.30 percent, the smallest margin since 2007, mere months before the largest financial crisis of our generation.

Stubbornly low long-term yields indicate a concern about long-term economic growth. It also brings us closer to the possibility of an “inverted yield curve,” which occurs when short-term bonds actually pay more interest than long-term bonds. When that happens, history suggests the economy is in trouble.

An inverted yield curve would no doubt be a powerful signal, but we are not there yet and other factors are at play.

Massive stimulus from central banks has had a larger influence on interest rates than in decades past. While the Fed’s asset purchasing concluded years ago, stimulus remains in effect across the Atlantic where the European Central Bank continues to depress global bond yields.

It’s also important to acknowledge the possibility that fears of an inverted yield curve become a self-fulfilling prophecy. Investors convinced a looming recession is inevitable may sell equities and buy safer assets like longer-term bonds. Such behavior would depress yields even further and could trigger an inversion even in a good economy.

Further, the last five U.S. recessions didn’t begin until 21 months (on average) after the yield curve inverted and the S&P 500 rose 13 percent (on average) in that time. In other words, the yield curve is worthy of your attention, but it’s foolish to base major investment decisions on any one factor.

 

Ben Marks is the chief investment officer at Marks Group Wealth Management in Minnetonka.