Everyone was screaming last year for the Federal Reserve to raise interest rates, saying they were too low. So the Fed is raising rates, granting the market its wish. Now the attention has turned to the flattening U.S. yield curve and the pending recession it could be signaling.

Is a recession coming, though? Is that really why the yield curve is flattening? A flattening yield curve does not mean a recession is imminent. The yield curve is flattening because the economy is improving, and that is a really good thing for stocks. (See also: Understanding The Treasury Yield Curve Rates.)

First, we must understand that yields are based on the future expectation of inflation, and the rate of inflation has been falling for nearly 40 years now, just as long-term yields have. 

The steepness of the yield curve is typically measured by the 10-year Treasury rate minus the two-year Treasury rate. 

We can see pretty clearly that the yield curve has flattened during every period of economic expansion, signaling recession only when the curve inverted. In fact, the yield curve typically steepens during a recession.  

We can see on this chart that the U.S. GDP grew quiet robustly through most of the 1990's. In fact, it rose more than 4 percent while the yield curve was flattening. 

It is incredibly important to understand what is the driving force for the flattening yield curve. Well, it's the Fed, of course. The Fed controls and dictates the short-end of the yield curve. Which, of course, is why we see a flattening yield curve during periods of economic expansion and a steepening during recessions. The Fed is driving short-term rates higher or lower depending on the economic cycle.

We can see quite clearly how the Fed drags the short end of the curve lower during periods of recession and pumps rates up during times of economic expansion. So it is the Fed that is inducing the flattening of the yield curve presently – not the market, as the Fed always does. If the Fed stops raising interest rates, then the yield curve will likely stop flattening. In a way, the fate of economic expansion is in the hands of the Fed. 

All of the hand-wringing regarding the flattening of the yield curve is premature, because as soon the Fed puts its foot on the brake of the tightening cycle, the yield curve will cease to flatten. In fact, it could be that if the Fed does continue to tighten, it would likely be doing so on the expectation of future economic growth, which, if true, should help inflation expectations rise and contribute to at least maintaining the current slope of the yield curve, or even help it steepen.

At this point, we likely have some time before we need to worry about a pending recession. In fact, use the Fed's recent rate hikes as an indication that it believes the economy will continue to improve. As long as the yield curve doesn't invert, we should be OK.

If you are anxious, just tell the Fed to stop flattening it. But you should be careful what you wish for. 

Michael Kramer is the Founder and Portfolio Manager of Mott Capital Management LLC, a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendation made during the past twelve months. Past performance is not indicative of future performance.

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