Is yield curve signaling a recession?

August 23, 2011: 1:59 PM ET
bonds, Treasuries

The yield curve has flattened in the past month. Click the chart to get current rates on Treasuries and other bonds.

NEW YORK (CNNMoney) -- Amid the growing number of signs that the United States may tip back into a recession, the bond market is sounding its own siren.

The closely monitored yield curve -- a key predictor of the economy -- has been narrowing all month and is now the flattest it's been since April 2009.

The indicator, which measures the difference between the yield on 2-year Treasury notes and 10-year Treasury notes, has shrunk to about 1.88 percentage points. Just a month ago, the figure was at 2.59 percentage points. That's not too far from where it started out the year.

So why the sudden collapse and what does it mean?

Recession 2.0 would hurt worse

In a normal, healthy economy, investors in longer-term Treasuries have to wait for their bonds to mature. So they typically want higher interest payments, or yields, to compensate for that.

A narrowing yield curve is a result of jittery bond investors buying up longer-term bonds without demanding much of a yield premium because they think the economy is headed for a downturn.

"The current yield environment suggests we could experience very weak economic growth or mild recessionary conditions for the next year or so," said Keith Hembre, chief economist at Nuveen Asset Management.

For example, Hembre said the recent tightening in the yield curve is consistent with a reading of about 40 in the Institute of Supply Management's manufacturing index. This figure fell to 50.9 in July, which is dangerously close to a decline in manufacturing activity. Any reading above 50 indicates the sector is growing.

Even though economic conditions aren't quite as bad as the yield curve suggests (yet), there has been a huge swing in investors' expectations for growth. That's sparked a flight to quality among longer-term Treasuries.

"We're dealing with a series of disappointing economic reports and a European credit crisis, and last month's deficit debate highlighted the fact that the government has a limited capacity to support economic activity in the event of weakness," Hembre said. "Together, all of those factors have led to a downgrade in the economic outlook."

Prospects for growth may be grim, but it could be worse.

Leading up to the last recession that began at the end of 2007, the yield curve actually turned negative. That phenomenon, also known as an inverted yield curve, happens when rates on U.S. debt maturing ten years down the line offer lower yields than short-term Treasuries.

While experts don't think the yield curve will invert this time around, mostly because short-term rates would have to rise and the Federal Reserve has pledged to hold them near 0% for another two years, that doesn't mean the U.S. is out of trouble.

Has the long end of the curve gone too far? - StockTwits

Experts also caution that the yield curve has been warped by the Fed.

"The yield curve has a lot of noise in it right now," said Kim Rupert, fixed income analyst at Action Economics. "The Fed's quantitative easing measures have distorted the bond market by compressing Treasury rates much more than they might have been without intervention."

Rupert said she hopes Fed chief Ben Bernanke doesn't hint at a third round of Treasury purchases when he delivers his keynote speech at the Kansas City Fed's annual retreat in Jackson Hole, Wyo., Friday.

"I don't think it's going to happen yet, but it would be nice to see the Fed start to unwind its positions in the Treasury market sooner rather than later," Rupert said. "Investors need to see some signs of increased confidence in the economy, and then we'll see Treasury rates start to move higher." To top of page

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