Recession Looming? Pay Attention To The Yield Curve.

The rally of the stock market last week has seemingly boosted the confidence of many investors, as the best weekly gain in almost 16 months was recorded.

Is the latest performance in the stock market a sign of good times ahead? Or should we hold a wait-and-see approach toward the latest rebound of the stock market?

The topic of recession has been mentioned very frequently recently, as analysts become increasingly concerned about the future economic conditions.

With geopolitical issues, the ongoing Covid-19 pandemic, inflation, and Fed rate hikes this year as some of the factors that are contributing to the volatility in the markets, the probability of a recession has increased, especially when the recent yield curve shows continuing signs of flattening.

But what does the yield curve flattening signify and why is everybody talking about this so often of late?

The yield curve is a two-dimensional plot of the interest rates on bonds for different maturities, with yields on the y axis and maturities on the x axis.

It is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth.

The slope of the yield curve gives an idea of future interest rate changes and economic activity.

We can see the various shapes of the yield curves in the image below ranging from Inverted, Flat, Normal and Steep yield curves.

A normal yield curve indicates yields on longer-term bonds may continue to rise, responding to periods of economic expansion.

An inverted yield curve instead slopes downward and means that short-term interest rates exceed long-term rates. Such a yield curve corresponds to periods of economic recession, where investors expect yields on longer-maturity bonds to become even lower in the future.

A flat yield curve is defined by similar yields across all maturities. Such a flat yield curve implies an uncertain economic situation. It may come at the end of a high economic growth period that is leading to inflation and fears of a slowdown and appear at times when the central bank is expected to increase interest rates (sounds familiar?).