Last updated October 2014

How are U.S. Treasuries performing this year? The answer depends on the maturity of the Treasury issue in question. So far in 2014, long-term bonds have performed very well: the yield on the 30-year Treasury has fallen from 3.97% on December 31 to 3.96% on October 8 (as its price rose), while the 10-year yield has dropped from 3.03% to 2.31% in that same interval. This shift is due, in part, to weaker-than-expected global economic growth and concerns about events taking place overseas, such as the conflict in the Middle East.

It's a different story on the shorter end of the yield curve, as the yield on the 2-year note has climbed from 0.35% to 0.45%, and the five-year yield - while falling - has only moved from 1.71% to 1.57%.

One reason for the weaker performance of shorter-term bonds is the concern that the U.S. Federal Reserve will begin to raise interest rates sooner than the middle of next year. Since short-term bonds are the segment of the market most affected by Fed policy, the prospect of eventual Fed rate hikes has pressured performance.

The result of the decline in long-term bond yields and concurrent rise in shorter-term yields is a flattening of the yield curve. In other words, the difference between the yields on long- and short-term bonds has been declining. While the gap between the 2- and 10-year notes stood at 2.68 percentage points at the beginning of the year, it had fallen all the way to 1.86 by October 8.

This is had a meaningful impact on performance results for those invested in bond funds.

Whereas the owners of long-term bond funds have prospered thus far in 2014, those in short-term funds have not – the polar opposite of what occurred in 2013. Last year, the Vanguard Short-Term Bond ETF (BSV) rose 0.15 % and far outpaced the -8.95% return of the Vanguard Long-Term Bond ETF (BLV). This year, the two funds have returned 1.48% and 16.51%, respectively, through October 8.

What Does the Flattening Yield Curve Tell Us?

Should investors read anything into this? Over time, a flattening yield curve has been a sign that fixed-income investors foresee an environment of slowing economic growth in the coming six to twelve months. That’s certainly the case right now, as the market has reacted to weaker growth data not just in the United States, but across the globe.

However, the real cause for concern occurs when the yield curve becomes “inverted,” meaning that short-term yields are higher than long-term yields. In many cases, this event has been followed by a recession and/or financial crisis within the following year. Right now, however, an inversion is nearly impossible due to the Fed’s ultra-low rate policy.

This helps underscore the problem of trying to read too much into the “shape” of the yield curve in the current era. Through its aggressive policies, the Fed has distorted conditions in the bond market, and nobody knows where the various Treasury maturities would be trading without the impact of Fed interference. Lacking the ability to draw historical parallels, investors are therefore left to guess just how much of a yield curve flattening is worth worrying about.

For now, then, the best bet is to keep an eye on the flattening yield curve, but don’t read too much into it. And, as always, it pays to make decisions based on your own goals and risk tolerance rather than recent market performance. If this trend continues through the middle part of the year, however, investors should begin to reasses whether the outlook for economic growth is truly as favorable as it appeared late in 2013.