What is a Flattening Yield Curve, and What Does It Mean?

If you don’t know what a flattening yield curve means, watch this handy graphic from CNN.

Many websites – such as Bloomberg – provide charts showing the current yield curve.

CNN provided an overview of flattening yield curves in a 2005 article:

The graph of bond yields in the Treasury market usually slopes upward, with yields on longer-term bonds higher than shorter maturities to compensate investors for taking on the additional risks of a longer-term investment…

If the curve flattens gradually, most traders said it probably means investors believe the Fed will keep future inflation in check with gradual rate hikes. Bond traders hate inflation because it erodes the value of their fixed-income investment.

But if the curve-flattening trend speeds up?

“It’s time to trade out of investments whose success depends on a strong economy… for both stocks and corporate bonds,” said Anthony Crescenzi, chief bond market strategist at Miller, Tabak & Co., an institutional brokerage.

This means reducing exposure to sectors like retail, transportation and automobiles and moving into defensive picks like health care and consumer goods.

But how does the market gauge whether the curve is flattening fast or slow?

Crescenzi said that over the last two years, the spread between the two-year note and the benchmark 10-year bond has shrunk by about 10 basis points per month. (100 basis points = one percentage point.)

But over the last year, the spread has diminished by 15 basis points a month, a faster pace that raised some eyebrows and sparked yield-inversion speculation. But, Crescenzi said, this seems reasonable since it is pretty much coincident with the Fed’s rate hike campaign.

“It is when the pace becomes much faster than 15 basis points a month that investors should start to worry,” he said.

Flattening Yield Curve Points Toward Deflation

PIMCO’s Bill Gross said:

There has been significant flattening on the long end of the curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re- emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.

Gluskin Sheff’s David Rosenberg, Tyler Durden and Mish also believe that a flattening yield curve indicates deflation.

Bloomberg writes today:

The yield on the 30-year bond fell 11 basis points, or 0.11 percentage point, to 3.94 percent at 1:31 p.m. in New York, according to BGCantor Market Data. That’s the lowest level since April 29.

Many analysts, such as Donald Dony, also argue that a flattening yield curve portends moves in the stock market.

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