The difference between short and long-term yields is termed as a yield curve. The most common is a steepening yield curve where the long-term yields are higher than short dated ones. The curve gets flat when the yield differential gets narrowed.
Investors with high-inflation expectations demand higher yields, which reflects in the greater long-term yields or a steepening yield curve. In contrast, a flat or inverted-yield curve throws signs of meager economic growth expectations.
Currently, the difference between US 2-year and 10-year yields stands at 0.3 per cent from 1.4 per cent during late 2016, while the gap between most referred 10-year and 30-year yields is worse at 0.13 per cent. The cure is now flatter than it has been ever been since pre-crisis 2007.
Why is the difference evaporating? Fed raising rates twice this year and preparing grounds to raise rates a couple of times have raised the short term interest rates well above the fed target range of 1.75 - 2.00 per cent. Concerns about the weak economic growth outside US, BOJ and ECB maintaining loose monetary policies, and massive bond purchase programme by Fed and other global central banks have capped the long-term interest rates from moving higher.
Banks usually borrow at short duration low rates and lend for a longer duration at higher rates. With a flat or an inverted-yield curve, banks’ net interest margin gets narrowed or may lead to negative margins (inverted curve) which leads to the liquidity squeeze and banks scale back in lending for corporates. During the last 50 years, the US economy experienced a recession in a year or two after an inverted yield curve. But, this time fed is looking at the picture differently and have also built the confidence in investors ruling out the possible effects of a flat curve. Fed sees the difference would be short lived and would not affect the economy.
The author is a fundamental research analyst at Karvy Forex and Currencies Pvt Ltd