The US 10-year treasury yield has fallen to 1.52%. However, as an investor, we not only pay attention to yield, but also look closer to the spread, i.e. the yield curve. The curve is a line that plots the interest rates, at a set point in time, of US treasury bonds having differing maturity dates. There are 3 curve shapes: normal, flat and inverted.
The normal and flat curve
Usually, investors see a normal (i.e. up-sloped) curve, which indicates the economic expansion and inflationary pressure rising. To control inflation, the central bank would raise the interest rate. For bonds with longer maturity dates, investors demand a higher yield in order to compensate the inflation risk. The flat curve occurs during the transition period between normal curve and inverted curve. In this period, the economy starts slowing down.
The relationship between the inverted curve and the US stock market
The inverted curve suggests the yield of the long-term bond yield is lower than the of the short-term one. This implies the economic growth may further deteriorate in the coming future. Recently, the US Treasury 2-10 year yield curve has been inverted, sending the biggest recession signal. However, on average, it takes 13 months to reach the US stock market peak after the inversion, with an average return of 21.8%. It is worth mentioning that even if the forecasting ability of the inverted curve is good, it did not help investors to avoid the 1987 stock market crash.
Does low inflation environment affect the yield curve?
Yellen, the former chairman of the US Federal Reserve, says that although the possibility of the US economy falling into recession has increased, the US should be able to avoid the recession. The inverted curve does not only be affected by future economic situation but also a series of factors. She points out that long-term bond investors may not demand to compensate for the inflation risks in current low inflation environment, making the curve more likely to be flat.