The U.S. Treasury Yield Spread
The spread (or difference) between the yields on the two- and ten-year U.S. Treasury notes is an important gauge regarding the current “shape” of the yield curve. The yield curve is simply the yields on bonds of varying maturities – typically from three months to 30 years – plotted on a graph.
Investors analyze the shape of the yield curve – and the changes to the shape – to gain a sense of economic expectations. When the market foresees an environment of stronger growth, higher inflation, and/or interest-rate increases by the Federal Reserve, the yield curve steepens. “Steepening" means that the yields on longer-term bonds rise more than the yields on short-term bonds. (Keep in mind, prices and yields move in opposite directions).
Conversely, when investors expect weaker growth, lower inflation, and easier Fed policy, the yield curve often flattens. In this case, the yields on longer-term bonds fall more than the yields on short-term issues.
One of the most popular ways to measure these changes is to measure the difference between the yields on the 2- and 10-year Treasury notes. The accompanying chart shows the difference in this spread over time. When the line in the graph rises, the yield curve is steepening (in other words, the difference between the 2- and 10-year yields is rising).
When the line falls, it means the yield curve is flattening (i.e., the difference between the 2- and 10-year yields is declining). When the line dips below zero, it means that the yield curve is “inverted” – or in other words, a rare case where short-term bonds are yielding more than their longer-term counterparts. With this knowledge, we can see various aspects of economic history displayed in the chart:
- Slow growth of the late 1970s: The slow growth of the late 1970s is shown by the 2- to 10-year yield spread moving into deep inversion on the left-hand side of the graph, while the recovery of the 1980s is reflected in the upward movement in the line thereafter.
- Warnings about downturns to come: The yield curve became inverted prior to the recession of the early 1990s, the bursting of the technology stock bubble in 2000-2001, and the financial crisis of 2007-2008. In each case, it provided an advance warning of severe weakness in the stock market.
- The post-2008 era: Since the financial crisis, the Federal Reserve has kept short-term rates near zero, which has depressed the yield on the 2-year note. As a result, the movements in the 2- to 10-year yield spread have been almost entirely the result of the fluctuations in the 10-year note. The volatility of the line in this interval reflects the uneven, shifting nature of economic conditions in the post-crisis era.
Keep in mind, shifting market forces can make the yield curve an ineffective indicator – for instance, the decline in the United States’ debt contributed to a decline in the 2- to 10-year spread during the late 1990s even though the economy performed during that time.