Yield Spreads

• The most common spread looked at is the US 10 Year Treasury Bond minus the US 3 Month Bill
• Typically look at long-term rates vs. short-term rates
• Long term rates usually are higher than short term rates
• Example:
• US 10 Year Treasury Bond Interest Rate = 3.5%
• US 3 Month Treasury Bill Interest Rate = 2.25%
• Yield Spread = 3.5% - 2.25% = 1.25%
• Falling US Treasury Yield spreads may help indicate an upcoming recession
• This erodes the profitably of banks
• Erodes the profitability of anyone borrowing short & lending long
• Studied by the San Francisco Federal Reserve
• Ten Year minus Three Month yield spread is "the most reliable" indicator of a recession in the next 12 months (compared to other spreads)
• All historical inversions have been followed by recessions
• A negative spread is not required.  Below a positive 40bp spread, historical recessions have occurred
• 17/17 flattenings since 1921 have resulted in a recession
• Falling yield spreads impact banks and other financial institutions that borrower short and lend long (reduced margins)

Flattening Yield Curve Impacts on Credit Quality

• When yield curves flatten, lenders tend to lower their risk premiums to keep profits up
• This setups up a bad situation (underwater loans)

Historical Examples Where the Fed Incorrectly Said Yield Spreads Don't matter

• The  Fed has said in the past that yield spreads are only one indicator - not very reliable
• In both 1989 and 1999 Alan Greenspan said that yield curve inversion was not relevant - the economy was still strong
• This was proven false - there was a recessions shortly after both times
• In 2008 Ben Bernanke ignored the yield curve collapse before the 2008 recession