The last few days of market turmoil may have you wondering, is a recession coming? One of many indicators that economists are watching is the yield curve. But what does it tell us?
What is the yield curve?
The yield curve is often referred to as an economic indicator – particularly as an indicator for a recession. Before we dig into the “indicator” aspect, let’s take a moment review what it is.
The yield curve plots the yield of U.S. Treasuries ranging from the one-month to the 30 year. There are four adjectives often associated with the yield curve – normal, flat, steep, and inverted. For the purposes of this article, we are going to focus on the normal and the inverted.
A normal yield curve gets its name because “normally” the shorter the bond’s maturity, the lower the yield and the longer the maturity, the higher the yield. Take CDs as an example. Typically banks will pay a higher interest rate for a 4-year CD than for a 2-year CD. The difference is the cost the bank pays you to use your money for a longer period of time.
Why do we care?
Inverted yield curves are relatively rare but are a normal part of economic cycles. Over the past 40 years the yield curve was inverted eight times, lasting at least one month at a time. The concern is that every recession, a total of five, over that same time period was preceded by an inverted yield curve. Based on these numbers, not all inverted yield curves lead to a recession but every recession was preceded by an inverted yield curve.
As the Federal Reserve raises the Federal Funds rate, the short term end of the maturities is rising and the long term end is not keeping up causing the yield curve to flatten. The chart below shows that one year ago (the yellow line) there was a .86% difference between 2-year and 10-year. The pink line reflects the curve on 08/24/2018 where the difference has reduced to .19%.
Just because the yield curve is flattening does not mean that it will become inverted. If it does invert, that does not mean that a recession coming. Remember, the yield curve can be a useful indicator but not a perfect one.