Written by Nick Place, Chief Lending Officer – Bridgewater Bank
Some interesting things have been happening with the yield curve lately. First, to back up and give some background about what the yield curve actually is. The yield curve is simply a line graph of the interest rates paid on treasuries with varying maturities. During most “normal” economic environments, the yield curve generally slopes up as the maturities extend out longer. This makes basic sense as one would expect to earn a higher rate of return if you were fixing your rate for a longer period of time. The typical difference, or spread, between short-term (say 2 years) and long-term (say 10 years) treasuries is around 1%.
However, this relationship where there is a wide margin between short-term and long-term rates has recently changed. First, the spread between the 2-Year and 10-Year treasuries has shrunk drastically, currently sitting at 0.17%. This takes slopes out of the yield curve, essentially flattening it out. Second, in a few points along this line graph the rates have become lower as you move out to a longer maturity. This can be seen currently where the 1-Year treasury is at 2.57%, the 2-Year treasury is at 2.50% and the 3-Year treasury is at 2.47%. This phenomenon of short-term rates being higher than long-term rates is called inversion. One might ask ‘Why is this important to me?’. The yield curve does not meaningfully impact any one specific metric in the economy, but it can be a gauge for and indicator of the market’s expectation of what will happen in the future. When the yield curve is inverted (the technical definition is where the 2-Year treasury has a higher rate than the 10-Year treasury), it can be a signal that an economic slowdown or a recession is on the horizon. In fact, an inverted yield curve has correctly predicted the last 9 recessions and has only had one false positive. Now a few things to note, an inverted yield curve does not cause a recession, and most importantly, the yield curve has not fully inverted yet.
The other large impact this may have on you is that the yield curve is directly related to what borrowers will pay on money lent to them from banks. Banks will typically base their interest rates off a spread to the current treasury rates or a similar index. Variable interest rates on loans have increased substantially over the last 2 years as the Federal Reserve has begun to gradually increase the Fed Funds Target. This rate directly impacts the Prime Rate, which is a common rate used by banks to price variable rate loans. The Federal Reserve has increased these rates by 2% in the last 2 years, so many borrowers with variable rate loans have seen their interest costs increase over this time frame.
Regarding fixed rate loans, in a normal rate environment a bank may offer a 2-year interest rate at a much lower rate than they would a 10-year rate. However, since the spread between these rates have become much lower over the last year (currently only 17bps), it may only cost you a little bit more in interest to fix your rate for a longer period of time. This has resulted in many borrowers using this flat yield curve as an opportunity to fix the interest rates on their loans for longer periods of time than they typically would. As we look out into 2019 there is a lot of uncertainty as to what may happen with interest rates.
Many have been predicting rates will continue to rise as the economy is firing on all cylinders with low unemployment, recent wage increases, favorable tax environment and strong corporate earnings. However, recent economic metrics have caused some to worry if these trends will continue. The stock market was down roughly 5% in 2018 and is down 15% from its peak, entering correction territory. Trade concerns, the government shutdown and a slowing global economy bring additional uncertainty regarding the likelihood that an economic expansion will continue. These concerns create uncertainty which ultimately will cause volatility in the interest rate environment. This volatility has been seen recently with the 10-year treasury reaching a high of 3.24% in November 2018, dropping all the way down to 2.69% by the end of the year.
Things to remember: watch the yield curve – it is very flat right now and IF it inverts, it could be an indicator that a recession may be on the horizon (treasury.gov lists its rates every day); variable rates have moved up, if you’ve been floating your interest rates your interest costs have increased quite a bit; long-term rates are attractive compared to short-term rates and this could be the time to fix your interest rate; lastly, nearly every economist polled in December 2006 predicted continued economic expansion between 2007 and 2008, so even the ‘smart’ guys don’t know what will happen down the road. Stick to your gut and try to make the best decision you can when working on any one transaction. Rates can only go up, go down, or stay the same; so you’ll always have at least a 33% chance of being right.