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PRINT EDITION
Flattening yield curve a worrying sign for investors, and the economy
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By SCOTT BARLOW
  
  

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Friday, April 20, 2018 – Page B1

The bond market is sending a disquieting signal to investors.

Both the Canadian and U.S. yield curves are flirting with what's called inversion, historically one of the most reliable - and dreaded - predictors of impending recessions and market weakness. Inversion occurs when the yield on the 10-year bond is lower than the two-year bond.

Currently, the domestic yield curve has the 10-year yield just over 30 basis points above the two-year yield, making it the flattest since 2007.

South of the border, the difference between two-year and 10-year Treasury yields is in the 45-basispoint range - also the smallest margin since 2007.

That's a key date, notably as a reminder that the U.S. yield curve was inverted for a full year before the financial crisis hit. Both the U.S. and Canadian yield curves also went negative just as the technology bubble burst in 2000.

An inverted yield curve has historically provided credible market warnings for investors. As Macquarie economist Ric Deverell wrote in a research report onThursday, "The [U.S.] yield curve has inverted within the 24 months preceding each of the past five recessions, and has only inverted once over this period without a recession following in the ensuing two years."

The other key factor is what those yields represent. The two-year bond yield acts as a proxy for current borrowing rates and the 10-year bond yield is used as an indication of the market's view of future economic growth and inflation. A flat or inverted yield curve in many ways represents the worst of both economic worlds.

Domestically, a climbing two-year yield means indebted consumers will make higher monthly payments when they renew their mortgages, while the low 10-year yield suggests the economy will be weak for the longer term. In short, it suggests that people will be paying more on their debts while they may not be making more in income in the future.

Mr. Deverell is not yet overly concerned with the U.S. yield curve, believing that the 10-year bond yield will pop well above 3 per cent later this year. (It's now at 2.91 per cent.)

He also notes that the relationship between the curve, the economy and markets is an all-or-nothing proposition.

An inverted curve is one of the most ominous investor signs there is, but a close to inverted curve doesn't reliably indicate that weaker business activity or equity markets are to come.

What does this mean for the sectors affected by bond markets? Many dividend-paying telecom, pipeline and utility stocks are already struggling as rising risk-free bond yields provide competition for investor assets.

Insurance companies, dependent on higher long-term bond yields to generate enough income to fund eventual liabilities, have also been volatile.

In the financial sector, domestic banks would prefer a steep yield curve because their basic business of loans involves borrowing funds at lower short-term rates and lending the proceeds to clients at (usually higher) longer term rates. The flat yield curve means bank profits are slimmer - the difference between their payments on shortterm borrowing and the monthly proceeds from longer term loans is not as large.

There will be no shortage of investors on both sides of the border who will panic if the yield curves actually invert and in that sense it could become a self-fulfilling prophecy.

Conversely, there are those who believe that the 10-year bond yield is artificially low - held down by retiring boomers desperate for income - and is no longer an effective estimate of future economic activity. (Investors close to retirement have been buying longer term bonds to lock in a stream of income, driving up the bond price. Because yields move in the opposite direction of bond prices, this depresses the yield.) If that is the case, an inverted yield curve would have far less drastic implications for future investor returns.

Investors ignored the inverted U.S. yield curve in 2005 and 2006, not trusting it as a negative indicator for markets. These investors, of course, paid a big price in terms of market losses as the financial crisis took hold.

There is no doubt that a flat or inverted yield curve is bad news for investors. An inverted yield curve in the next few months doesn't necessarily mean the same terrible things as in the past - it's entirely possible that demographics and unprecedented postcrisis central bank monetary stimulus have distorted the yield curve and its signal.

But these concerns likely won't matter. After having missed the yield curve's warnings before 2007, investors are unlikely to make the same mistake twice. We should hope Mr. Deverall is right and the yield curves will soon steepen, because an inverted curve would almost certainly cause intense market volatility this time.

Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.


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