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The U.S. Yield Curve Is Sending the Right Signals

Recent yield-curve flattening is likely to more strongly affect smaller banks, reducing their profitability.

By David Ader | Updated on July 16, 2018
U.S. Federal Reserve building in Washington, D.C. Photographer: Joshua Roberts/Bloomberg

When it comes to assessing the outlook for the U.S. economy these days, the discussion usually starts with the bond market’s yield curve. At less than 30 basis points, the difference between two- and 10-year Treasury yields is the narrowest since 2007.

This is classic late-cycle behavior. The curve is signaling that the market thinks the Federal Reserve’s interest-rate increases, which are driving short-term yields higher, will not only slow inflation, but could also tip the economy into recession, causing long-term yields to go nowhere or even fall. The point is that the yield curve is not just a signal, but something that could actually weigh on the economy. Why? Because higher short-term rates make adjustable-rate loans more expensive and lower long-term rates eat into the profitability of banks, which tends to lead to lending restraint.

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