The FOMC minutes released yesterday recorded that several members of the Committee are worried that a flat yield curve “foreshadows” an economic slowdown and therefore the Fed should think twice about pushing the fed funds rate higher in 2018. That is another example of analysis that ignores current conditions that make past relationships misleading. The reason flat yield curves preceded recessions in past cycles is that by the time curves became flat, short term rates and bond yields were high enough to cause a recession. Today, with rates the lowest of our lifetime, another 100 basis point increase in the funds rate to around 2 1/4-2 1/2% would probably not be sufficient to cause a slowdown.
Investors, however, should worry about flat curves because they impart more market risk to long duration securities. When curves are steep, short-term rates can rise and bond yields often rise far more slowly. For example, in 2004 and 2015, before the Fed began to raise the funds rate, the 30-year to 2-year spreads were as great a 300 basis points. Bonds performed remarkably well as the funds rate rose. Once the curve is flat, however, it tends to move up in parallel fashion if short-term rates keep rising. The extreme example was in 1978 when the curve became flat with 2- and 30- year yields at around 8.50%. By 1981, the yield on the 30-year reached 15%, Ouch! Beware of long maturities when curves are flat and short-term rates are likely to keep rising.