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Flat Is For Pancakes, Not Yield Curves

One is delicious; the other is not.

Economist, Author, and Five Star Wealth Manager

Ivan Illán has excelled in both institutional asset management and financial advisory for more than 20 years. Ivan’s work has been featured in numerous articles including, The Washington Post and The Wall Street Journal. He’s a Forbes Contributor and Finance Council Member. Ivan is also ranked as a Financial Times Top Financial Adviser. He holds degrees in finance and philosophy from Boston College, the Certified Fund Specialist (CFS®) designation from the Institute of Business & Finance, and is a member of the CFA Institute, New York Society of Security Analysts, and CFA Society Los Angeles, where he’s a Founding Member of the Wealth Management League.
Ivan Illán has excelled in both institutional asset management and financial advisory for more than 20 years. Ivan’s work has been featured in numerous articles including, The Washington Post and The Wall Street Journal. He’s a Forbes Contributor and Finance Council Member. Ivan is also ranked as a Financial Times Top Financial Adviser. He holds degrees in finance and philosophy from Boston College, the Certified Fund Specialist (CFS®) designation from the Institute of Business & Finance, and is a member of the CFA Institute, New York Society of Security Analysts, and CFA Society Los Angeles, where he’s a Founding Member of the Wealth Management League.

Image via jeffreyw/Flickr CC

I love pancakes. Especially the fluffy ones made from buckwheat flour (supposedly healthier due to higher fiber content). Aesthetically, they must be uniformly flat and sized, so they can be easily stacked, syruped, and sliced with your fork. If you’re salivating, now read about the much less appetizing flattening yield curve.

All interest rate yield curves result from plotting bond maturities on the x-axis with their corresponding bond rates on the y-axis. A healthy curve starts low in early years and ends much higher in later years. This follows a basic principal of risk and return, which all good investors understand. Over a very short time, since you’re taking little risk (uncertainties are less in the short-run) then you deserve very little return. Conversely, the longer time you spend separated from your money, the more return you’ll need to compensate you for the additional risks from more uncertainties and opportunity cost. A flat yield curve is just that – flat across various time horizons. Flat yield curves are not only visually unappealing (particularly as compared to flat pancakes), but they are very, very dangerous harbingers of economic problems if not corrected soon enough, as they violate a basic principal of risk and return.

The Federal Reserve has sounded slightly more hawkish on interest rates, looking to prime the pump on ratcheting up. This should serve as a warning to market participants, but for various reasons, the Fed’s words are falling on mostly deaf ears. U.S. inflation rate expectations are extremely low – looking at the forward swap market on U.S. treasuries or on the 2-10 Year Spread (chart above) – shows us how little bond investors get paid to loan money for 8 years longer.

For an additional 8 years of loaning money to the government, an investor could expect to pocket a whopping 0.87% more per year (as of the writing of this, it’s down to 0.84%). This is a nominal rate, which means if you factor in inflation of just 2%, your real return is only 0.15% per year (with the current 10 Year yield of 2.15%). It’s downright punitive.

We may be at risk to move even flatter, which increases the risk of an inverted yield curve (which the chart above shows the occurrence of in dramatic log scale). My suggestion is to start behaving and making decisions as if interest rates are going higher, since I am convinced The Fed will not allow inversions like we’ve seen regularly over the past four decades.

Every inversion has predicted a U.S. recession (shown in gray shaded areas on chart). However, with tax and regulation reforms coupled with a potential $1Trillion infrastructure spending plan on the horizon, inflation and higher interest rates are much more likely outcomes.