Canada’s Yield Curve Is Flattening As Investors Trim Long-Term Growth Expectations

Central banks may have held rates too low for too long, making it difficult to normalize. The US is now discussing the flattening of the “yield curve,” often a sign of an economic slowdown. Canada is ignoring a similar discussion, despite flattening even faster than the US. Flattening quickly turns into yield curve inversion, considered a leading indicator of recession.

The Yield Curve Steepening, Flattening, and Inverting

A yield curve is a plot of yields and terms for government bonds, and is watched very closely. Healthy economies have a yield curve sloping up, like a takeoff of an airplane. Short-term bonds, like a 2-year Government of Canada (GoC) bond, have a smaller yield than longer terms. After all, there’s more uncertainty and risk the further out one tries to forecast. More risk requires more compensation as motivation, in this case with higher yields.

Yield curve flattening is when short and long-term yields approach similar levels. If an investor considers the same risk for a 20- and 30-year bond, there’s uncertainty about the future. The 10-year and 2 year GoC bond is typically used for a quick read, and the closer it gets to zero the worse the outlook. If things get really bad, the market can see yield curve inversion.

Yield curve inversion is when short term yields are higher than long term ones. Investors are more uncertain about the future, and think this is as good as it gets. US Federal Reserve research shows this has been the most effective recession forecasting tool in history. After inversion, a recession is seen as quickly as six months after.

Canada’s Yield Curve Is Flattening

Canada’s yield curve is flattening and it’s brutally obvious when contrasted to a year ago. The gap between the GoC 10- and 2-year bond yields fell to just 37.6 basis points (bps) on Feb 14. This is down from 93.1 bps a year ago and 130.6 at this cycle’s peak in March 2021. There is still a gap, but the curve looks a lot less healthy than a year ago when banks began suggesting higher rates.

Canadian Yield Curve

The percent yield for Government of Canada bonds by length of term on Feb 14, 2022 compared to a year before.

Source: Bank of Canada; Better Dwelling.

The above chart shows how much healthier Canada’s yield curve looked a year ago. One point that probably stands out is the GoC 20-year is 2.150% and the 30-year is 2.136%, lower but longer. Once again, this is never a great sign to see long-term yields collapse below short-term ones. Rate hikes will apply more pressure to short-term yields than long ones. In this event, if hiking interest rates doesn’t change the long-term perspective, the curve flattens further. 

The US Yield Curve Is Flattening and People Are Sounding Alarms

The US yield curve looks stronger compared to Canada, but concerns about flattening are already in the media. The spread between the US 10- and 2-year treasuries (their government bond) is at just 42 bps on Feb 14. It was about 109 bps a year ago, so this gap is also closing fast. It’s a broader gap compared to the one seen in Canada that isn’t getting nearly as much attention. Talks about aggressive hikes to curb soaring inflation are dampening long-term growth.

US Yield Curve

The percent yield for US Treasuries by length of term on Feb 14, 2022 compared to a year before.

Source: US Federal Reserve; Better Dwelling.

Economists were very vocal about raising rates a year ago, when the curves were healthier. The recovery was well on its way, home prices made modest gains, and inflation was just heating up. The economy was much better positioned to handle a rate increase. Instead central banks leaned on the non-productive growth and embraced excessive inflation. Now they have to balance the two — slowing down inflation or the economy.