The flat yield curve will pose a problem during the next severe economic downturn.
Continue Reading Below
Markets are pricing in low but increasing odds the Federal Reserve will need to cut rates to zero or into negative territory to combat the next recession. The central bank has just eight 25-basis point cuts left in its arsenal before hitting a zero percent interest rate, and will likely use the majority of those rate cuts by the end of 2021, according to Bank of America global rates and currencies research analysts.
A basis point is one-hundredth of 1 percentage point and a widely used measure for changes in interest rates. For example, if the Federal Reserve's target rate was 2 percent and it was cut by 50 basis points, the new rate would be 1.5 percent.
“With only three remaining 25 basis-point cuts left, it will not take too severe of a macro shock to get the Fed back to zero,” analysts Mark Cabana and Adarsh Sinha wrote Wednesday in a note to clients.
Ahead of the 2008 financial crisis, the benchmark fed funds rate hit a peak of 5.25 percent, giving the central bank room for 21 standard-sized cuts; some of them were much bigger, but the Fed was unable to steer the economy away from the worst downturn since the Great Depression.
That prompted the central bank to try alternative tactics, like quantitative easing, or the purchase of long-term government bonds to inject cash into credit markets and spur lending. With an inverted yield curve, where investors are already more willing to buy long-term notes than short-term ones, the Fed might fear that quanitative easing would only worsen the situation.
Typically, a bond investor receives a higher yield for holding longer-term notes than shorter-term ones. That causes the yield curve, as pictured on a graph, to slope from the lower left to the upper right, signaling investors are more confident in near-term strength. A positive spread between the U.S. 2-year and 10-year yield also reflects investors thinking they can earn better returns in assets like stocks than in Treasurys.
But in some cases, the yield curve flattens, signaling the economy is slowing down and causing investors to shed riskier assets like stocks in favor of longer-dated Treasury notes and bonds expected to be a better store of value over time.
On Aug. 14, the spread between the U.S. 2-year and 10-year yields turned negative for the first time since 2007. Such a development has occurred ahead of each U.S. recession of the last 50 years, sometimes leading by as much as 24 months.
And while the 10-year yield currently has a 2 percentage point premium to a 2-year yield, it is the relative flatness of the curve that has the Bank of America analysts so worried.
To avoid skewing the long-term markets further, they think the central bank would need to use tools on the “outer rim” of monetary policy, like yield curve control, which the Bank of Japan sometimes uses, buying mortgage-backed securities or pushing interest rates into negative territory.
But in the Fed's view, there's little reason to worry at present.
"I wouldn't see the recession as the most likely outcome in the U.S.," Fed Chairman Jerome Powell said during a question-and-answer session in Zurich, Switzerland, on Friday.