What's the message from the yield curve

Should traders start looking towards safe havens? Already? The economy just recovered...The FOMC has performed two interest rate hikes this year - and has hinted towards two more by the end of the year.

This confidence in the economy isn't unfounded; unemployment is at its lowest levels since 2000 - basically pre-recession levels, personal income is up 0.4% MoM, personal consumption expenditures and disposable personal income are also up 0.3%.

The public's opinion and confidence in the economy's health is positive. Why are some people then, including Minneapolis Federal Bank President Neel Kashkari, worried about the yield curve then?

The economy is recovering?

Political rhetoric is constantly pointing out that the economy is completely fine - unemployment is at just 4% and inflation seems to be waking up after its recession period hibernation.

Certain sectors of the financial markets are even enjoying a swell in activity. Forex traders and brokers for example, are having a great 2018.

The volatility caused by a certain tweeting world leader, the cloud of divisiveness surrounding Brexit, a weaker dollar and the news that most Central Banks were looking towards slowing QE - have caused a spike in Forex trading volumes this year.

Learn more about how to stay ahead of the markets

On the surface everything seems healthy - but we have seen a five week consecutive drop of 10 year notes yields. This is what is making economists nervous. The rates are currently (July 17th 2018) at 2.86% which is still better than the year to date rate of 2.31%. There are two other items here to consider though:

A) 2 yr. notes this time last year were at a paltry 1.36%. Today's 2 yr. rate is at a relatively high at 2.62%.

B) this means in mid-July 2017 the rate margin was a comfortable 0.95% (the average being 1.24%) compared to today's slim 0.24%.

Using the previous recession as a benchmark, the last time the rate difference between 2 yr. and 10 yr. rates where in the same region as today was the end of July 2005. The curve inverted on December 29th 2005 and remained inverted (or only showing a few decimal percentage points difference) leading into 2008 when the recession began.

From the time a roughly 0.24-0.26% difference was recorded until the curve inverted was just a few months. The economy went into a full-on recession roughly 2.5 years after that time.

So, maybe Neel has a point.

Flat yield curve

If you are unfamiliar with the term yield curve it is essentially a graph which plots the maturity of government bonds against the interest rate they offer - obviously the healthiest is when longer term bonds yield the highest rates. This causes an upwards sloping yield. Inversely an inverted slope seems to be a pretty solid indicator of an impending recession, as demonstrated above - although the time between inversion and recession can vary.

Many market commentators and analysts are pointing to the Flat Yield Curve as a harbinger of a new recession. Some have gone as far as drawing parallels between the market and economic conditions preceding the 1969-70s recession. Even though the U.S. economy today is considerably robust - especially when you look at all the confidence-shocks its been through since 2016.

Ear to the ground

Inflation is low, unemployment is down to pre-recession lows, US Gross Domestic Product is $19.39 Trillion, (compared to 2009, the official year the recession ended, $14.46 Trillion) and June Retail Sales showed a 0.5% increase MoM overall proving consumers' confidence in the economy.

Markets know well that whatever goes up must come down. That's why analysts are constantly looking for predictors or stress factures indicating a downturn in an economic cycle. When it comes to the yield curve, an inverted one specifically, has preceded all but one of the seven recessions since the 60s.

There is a further break-down to this dynamic according to University of Western Ontario economist Stephen Williamson. He claims that recessions usually see a narrowing of margin between 2-year bonds and 3-month notes. The flat trajectory the curve is following at the moment is reflected in the comparison between these two also.

The reason a flat yield curve is worrisome is that this figure's graph is more or less a repeated parabola - peaks and ebbs or cycles. The flat may likely be the peak of an upwards curve to be closely preceded by a inversion and likely a recession.

source: http://www.wealthmanagement.com/fixed-income/what-flattening-yield-curve-means-your-clients

Trading during a recession

First if you are trading CFDs then you have nothing to worry about. CFDs allow traders to benefit from both the drop or the rise of the underlying asset's movement.

The most common strategy when everything is dropping is to go short. Another, less traditional and more controversial technique is called - value investing. Basically, you buy into an asset at rock bottom and then hold it until it recovers. Hedging is also used to protect traders against more volatile assets.

Investors that hold their assets for extremely long periods of time, 20 or 30 years for example, probably won't even feel the dip as its averaged out by periods of market growth.

Finally, the best risk management strategy is actually keeping in mind that markets are cyclical; having failsafe's in place to protect you and your investment against that outcome is imperative.

Do you think the flat curve yield is an indicator of an upcoming recession? Let us know in the comment section below.