What do yield curves tell us about the outlook for the world economy?

FactSet’s Sara Potter, VP, Market Analysis, offers insight on how a country's yield curve can be an indicator of economic stability.

With the global economy’s path looking uncertain, one interesting metric to look at is a country’s yield curve. Steep yield curves can indicate expectations of strong economic growth, since economic expansions generally bring higher inflation and interest rates. A flattening yield curve indicates greater uncertainty about the economic outlook. Currently, global yield curves are mostly upward sloping, but there is a lot of variation between curves. In recent months, most countries including the United States have seen a flattening yield curve as the global economic recovery falters.

A quick measure of the slope of a yield curve is the spread between 10-year government bonds and 3-month bills.  Interestingly, the countries at the extremes by this metric are Italy (5.3), Spain (4.9), Portugal (-6.5) and Greece (-75.4). Italy’s credit rating was recently downgraded by both S&P and Moody’s due to a weakening economic growth outlook, so the steep curve is simply a reflection of expectations of higher interest rates. Similarly, Spain has been warned of a potential rating cut by the leading credit agencies. The sharply inverted curve for Greece indicates that the bond markets have priced in a Greek debt default, with overnight and one-month bills currently trading with yields over 100%. Portugal’s curve is not quite as steeply inverted, but there is still a lot of near-term risk priced into that market. For the other country hit hard by the European debt crisis, Ireland, the yield curve is upward sloping but still pretty flat as the country shows initial signs of economic and financial recovery.

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Yield curves in the Asia Pacific region are mostly flat across the board. One unique case is Australia which is inverted on the short end, but upward sloping in the medium- and long-term section of the curve. In this case, the market appears to have priced in a 100 basis point rate cut by the Reserve Bank of Australia in the next year. The two largest economies in the region, China and India, both have seen their curves flatten considerably in recent months as the global economic outlook has weakened. 

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The other two BRIC countries, Brazil and Russia, both find themselves in the middle of the pack with moderately upward sloping curves.  The slope of Brazil’s yield curve has steepened over the past couple of months as the central bank has been under increasing pressure from the government to cut the country’s key short-term interest rate; the central bank already cut the SELIC by 50 basis points on August 31. It’s clear that while emerging markets face different challenges than those in the developed countries and are not facing immediate default or recession, they are still at the mercy of the state of the larger global economy.

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