A Flattening Yield Curve: What Does It Mean?

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You know, prior to having a kid, I never understood parents’ burning desire to get out of the house and have adult conversations. But now that I have one, I totally get it. Your entire day just ends up revolving around the baby. What does it eat? Why is it crying? What consistency is its poop? Ugh.

So thank God we have this blog and I get to write about topics that are the exact opposite of poopy diapers: bond yield curves.

So buckle up everyone, it’s ADULT CONVERSATION TIME! WOOO!

What have Bond Yields Been Up To?

While pretty much everyone has heard about central banks jacking up interest rates over the past year, what I’ve found much more intriguing is the weird yield curve this has created.

To recap, the yield curve is a graph that you get by charting out the interest rates you can get for bonds ranging from 30 days to 30 years. Normally, this graph looks like a line that slopes up and to the right, like this…

This reflects the fact that investors want to be compensated for locking up money for longer periods of time. After all, why would you buy a 20 year bond when a 1 year bond is paying the same amount. This is especially pronounced during periods of high inflation, because the same amount of money returned to you in 20 years is worth less than that amount in today’s dollars, so you need to earn more of a return on it to make up for that lost purchasing power.

Which is why it’s been so strange that the yield curve has been going in the opposite direction all year.

This is the US treasury yield curve at the beginning of 2023, and it’s the reason why we’ve been in this bizarre situation where bond ETFs have been sitting at a yield of 3-4% even while you can find savings accounts paying 4-5%.

That’s not normal, and is what’s known as an inverted yield curve.

The reason why this is happening is that investors are crowding into long-duration bonds, artificially keeping their yields low. The reason why they’re doing this is because they’re expecting a recession. During recessions, central banks tend to drop interest rates to stimulate the economy (just like what happened during the pandemic), and when that happens, long-duration bonds tend to to shoot up in value. So an inverted yield curve basically means that bond traders are betting on a recession just around the horizon.

However, this article isn’t about the inverted yield curve. It’s true that inverted yield curves tend to predict recessions, but there have been situations where inverted yield curves didn’t result in a recession, and recessions have happaned that weren’t preceded by an inverted yield curve. Inverted yield curves simply mean that bond traders are guessing a recessions is coming up, but it’s just a guess.

What is interesting is something I’ve noticed happening over the past few months.

The yield curve is starting to un-invert.

In this chart, the orange line is the yield curve from 6 months ago. The green line is from one month ago. And the blue line is right now.

And this isn’t just the US. You can also see the same pattern starting to emerge on the Canadian bond market.

Much has been written about the inverted yield curve, but this situation really only had two ways of ending: A recession really does happen, or bond traders eventually go “Oh, I guess it’s not that bad after all,” and the curve gradually floats back to normal.

The second scenario appears to be happening.

What Happens when the Yield Curve Flattens?

The yield curve flattening is generally a sign of cautious optimism, since bond traders are starting to think that we might not be headed for a recession after all. But with all things economy related, changes like this produce all sorts of knock-on effects on the wider economy. Some of it’s good, but some of it can be bad. It all depends on where you’re sitting in this giant system of market-based capitalism that we all live in.

I don’t have a crystal ball, and something could easily happen that causes fears of a recession to come back, but if the yield curve continues to normalize the way that it’s doing now, here are some of the things we can expect.

Effect 1: Bond prices will fall

As bond yields go up, prices for existing bonds will go down. That means that we’re probably in for some downside on bond funds.

The central bank isn’t expected to make any more huge interest rate changes (there may be one more 0.25% hike, but that’s it), so most of the movement on the yield curve is happening at the longer part of the curve. This means that longer duration bonds are going to the most affected.

While I never advise ditching your fixed income holdings completely, if this happens short duration bond funds or money market funds will be the least affected. Shortening the duration of your bond holdings would be one way of weathering the storm. Plus, money market’s paying like 5% right now, so that ain’t bad for a risk-free asset.

Effect 3: Stock prices will also fall

Yeah, I know. I don’t like it any more than you do, but when bond yields rise up to the 5%+ level, stocks start to look not that attractive. We’re not that far off from that now, and it’s already having a negative effect on equities. As of the time of this writing, the Dow Jones Industrial Average has given up all the gains for the year, and the S&P 500’s not looking so hot either.

But keep in mind that equity prices are even harder to predict than fixed income, so don’t use this as an excuse to dance in and out of the market. After all, even if you successfully time your exit to cash to miss the coming volatility, how do you know when to get back in? Most likely, you’ll miss the boat, so don’t try.

Instead, use this as a buying opportunity to pick up stocks while they’re on sale. I’m planning on dollar-cost-averaging any income that I earn into the stock market, and you should too!

Remember: Time in the market beats timing the market.

Effect 3: Mortgage Rates will Rise

If you’re one of the millions of heavily indebted mortgage holders out there choking on rising interest rates, you’re not going to like this.

Mortgage rates aren’t actually tied to the central bank interest rate that the media keeps talking about. They’re actually priced off certain parts of the yield curve. Specifically, Canadian mortgage rates are tied to the 5-year bond yield, and American mortgages are tied to the 10-year yield.

Those are the parts of the yield curve that are rising right now.

That means that even if central banks stop raising the benchmark rate right now, that won’t stop mortgage rates from going up. As the yield curve normalizes, it’ll pull up the 5-year and 10-year yield with it, and unless something changes, mortgage rates are going along for the ride.

Just looking at the curve lines, a “normal” 5-year yield would be in the 6-7% range, and the 10-year yield should be even higher. That would put mortgages in Canada above 8%, and the US one above 9%.

Combine that with the fact that house values drop when mortgage rates rise, this could be the start of a whole new cycle of pain for the housing market.

Hopefully I’m wrong, because people are already suffering enough trying to pay their mortgages as is. But if I’m reading these charts right, yikes.

Effect 4: Fixed Income Will Pay Better

On the plus side, after all. is said and done, fixed income investments should finally start paying a decent return again.

That’s why I’ve positioned the fixed income portion of our portfolio in Preferred Shares, which should float up in both yield and price as the yield curve normalizes. This is because as preferred shares mature and renew, they reset their dividend rates to the 5-year bond yield, and because yields on that part of the curve are now higher, it will cause dividends to increase, and their value to increase as well. So the effect that’s hurting mortgage holders should help preferred share investors.

Conclusion

So that’s my hot take on what appears to be a flattening yield curve. What do you think? Will bonds continue to normalize, or do you still think we’re heading for a recession? Let’s hear it in the comments below!

Aaaand the baby’s crying again. Gotta go, duty calls!

Update: Volatility Returns

And just like that, everything changes once again. The recent breakout of war in the Middle East over the weekend has caused volatility to return back to the stock market this morning. Markets hate uncertainty, and you can’t get more uncertain than this.

It also happened right after a surprisingly positive labour report from the US showing abnormally high job gains. So now we have two forces pulling in opposite directions.

But regardless of where the volatility comes from, index investors like us shouldn’t make any trading decisions based on the day-to-day news, and this situation is no different. Stay off your trading accounts today, and let’s all hope things calm down quickly and peacefully soon.


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17 thoughts on “A Flattening Yield Curve: What Does It Mean?”

  1. The only prediction I’ll make, based on nothing but intuition, is that housing prices will continue rising along with rising mortgage interest rates, at least for a while.

    1. The cost of labor and materials will continue to rise. No disinflationary affects in the housing market. Rising rates may keep a lid on rising home prices temporarily but when rates fall they will continue marching north.

  2. The yield curve is flattening, this is true. But not because short rates are receding. Long rates are rising. The enormous sums needed to finance the fiscal deficits combined with the fed selling its portfolio of T-bonds and mortgage is soaking up investor (insurance, endowment, and pension) money.

    The fed is driving up the long rates by unloading all of the T-bonds and mortgages that they bought during the covid quantitative easing. They don’t have to sell now, but they are.

  3. Couch Potato all the way! I had an assessment that said I would have leftover money if I died in my 90s so I actually threw about 10% in TQQQ (about 5% from TFSA), a triple leveraged NASDAQ 100 ETF (just read Life Cycle Investing). This is gonna be some roller coaster ride. The backtest analysis is beautiful but I realize the last 13 years of its existence was quite tech favorable and NASDAQ is very tech heavy. Lets hope that AI is a big as the bulls are saying.

  4. The word “why” should never follow the word “reason.” It is incorrect English. Take the “why” out of your sentence and re-read the sentence and you will see that the word “why” is completely superfluous and unnecessary.

  5. Higher loan default rates, lower savings, record debt, inflation, and lower consumer confidence/spending…I don’t know how these sharp increases in home prices can last either..as said they became detached from fundamentals a few years ago.

  6. Are you at all concerned by the terrible track record (long term negative total return) of that preferred shares ETF?

  7. I like to use a CD ladder instead of bonds for the part of the portfolio from which I draw out money.
    When I built it, interest rates were uber low, so to avoid tying up money for 4 years at those rates, I doubled each rung of the ladder. It worked to mature twice what I needed for my draws, the surplus got reinvested and I caught some interest rate increases. If the curve ever straightens out, I’ll reinvest in the normal way of building a CD ladder.
    I don’t think a recession will hit the US (nor probably Canada), and my opinion is worth exactly what you are paying for it. War tends to be profitable for the countries not invaded, and it looks like there is plenty of that activity underway.

  8. Hi guys! Congrats on your new addition! So exciting!
    Question for you…would you be willing to share your current portfolio? 🙂

  9. Raising interest rates is a great time to use a laddered CD portfolio for the fixed income part of your portfolio.

    The portfolio can have CD`s maturing every 6 months to get the interest rates as they go up. Someone might buy a 3 year CD every time a CD comes due. You are guaranteed to get you money back at maturity and it reduces `interest rate` risk.

    Not sure what sort of preferred stocks are available, but historically they were described as the worst of both worlds; lacks the bankruptcy protection of a bond, and in a growing economy they don`t raise their dividend like common stock. If the tax code hasn’t`t changed, the dividends paid shareholders are not a deductible expense like bond interest, so it is a very expensive way for a company to borrow money. Maybe this is all changed in the past couple decades.

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