Davide Barbuscia, David Randall

NEW YORK, (Reuters) – The U.S. Treasury yields curve has been flattening in recent months as the Federal Reserve plans to raise rates. Some analysts predict more drastic moves or even an inversion.

Investors pay attention to the shape of the yield curve. It influences asset prices and feeds into bank returns. In turn, it predicts the future economic performance. This is a brief primer on what an inverted, steep or flat yield curve looks like and how it can predict the next U.S. depression.

WHAT IS THE U.S. TREASURE YIELD CURVE?

U.S. Treasury is a debt issuer that finances the federal government’s budget obligations. There are $23 trillion in Treasury bonds, including Treasury bills that mature one month to one year and notes with maturities ranging from 2 years to 10 years. Also, there is a 20-year bond market.

The yield curve represents the yield on all Treasury securities.

What SHOULD A CURVE LOOKS LIKE?

The curve tends to slope upwards as investors are willing to accept higher risk of rising inflation and take on more compensation. A 10-year note yields more than a 2-year bond because its duration is longer. The yields are related to the prices.

A steepening curve usually indicates higher economic activity and inflation. It also signals higher interest rates. An opposite can be true: flattening means investors are more likely to expect higher interest rates in the immediate future and may lose confidence in the economic growth outlook.

WHY IS THEYIELD CURVE FLATTENING NOW?

Short-term yields on U.S. government bonds have been increasing rapidly this year, reflecting the expectation of several rate increases by the U.S. Federal Reserve. However, longer-term government bond yields have increased at a slower pace due to concerns about policy tightening.

Therefore, the Treasury yield curve’s shape has generally been flattening. One closely watched section of the curve measures the spread between two- and three-year yields. The gap is approximately 60 basis points. That’s nearly 20 points more than it was at the end 2021. Investors viewed Fed officials as a little less hawkish, and this led to the flattening of the curve.

Rate increases are a tool to fight inflation but they can also be used as a cost-cutting measure for all types of loans, including mortgages and car loans.

The two-year U.S. Treasury yields which are used to track short-term interest rates have increased 60% from the 0.73% they were at the beginning of last year. They now stand at 1.16%.

The benchmark yields on 10-year U.S. bonds have increased to 1.8%, up 20% from 1.5%.

What does an INVERTED CURVE MEAN? AND WHEN WILL IT HAPPEN?!

Some strategists and investors are beginning to predict a curve-inversion as early as next year, which is a worrying sign.

According to an 2018 study by the Federal Reserve Bank of San Francisco, the U.S. curve inverted prior to each recession, with a recession occurring between 6 and 24 months after that. In that instance, it was a false sign.

In 2019, the yield curve was last inverted. In 2019, the yield curve was inverted again. The United States went into recession the following year, albeit due to the pandemic.

Strategists Standard Chartered LON: Bank forecasts that the curve will be flat at mid-year, and possibly invert by year’s end.

Larry Fink (NYSE:) is the chief executive at BlackRock, which is the largest asset manager in the world. He has warned of a potential curve inversion.

IS THE WHOLE CURVE INTERESTED OR JUST PARTS?

Traders often monitor the yield curve by comparing 10-year Treasury Notes and two-year Treasury Notes. This is because an inversion of that spread’s yield curve would have predicted previous recessions. Currently, it is flattening. However, inversion is not imminent.

However, there are many distortions that can be made along the curve.

Friday’s curve was less well-watched, as the U.S. Treasury 10-year note premium over 7-year Treasuries briefly slipped into negative territory.

Since October’s end, the 20-year/30 year spread has been negative. However, technical supply and demand factors might have helped.

What does this mean for the real world?

Apart from the signals it can flash on the economy’s health, the yield curve shape has important implications for business and consumers.

U.S. Banks tend to increase benchmark rates in order to make borrowing more costly for their customers when the short-term rate rises. Also, mortgage rates are rising.

Banks can borrow money at lower interest rates while lending at higher rates when the yield curve is steeper. In contrast, banks may find that their margins are squeezed when the yield curve is flat. This could discourage lending.