At your next social event, try asking a family member, friend, or even a total stranger if they think we are headed towards an inverted yield curve. They just might be impressed, though more likely, they’ll quietly slink away.
Before you pose the question though, here’s a quick primer.
A yield curve is simply a line that plots interest rates at a set point in time for bonds having equal credit quality, but differing maturity dates. Most commonly, the yield curve is referenced to compare interest rates on three-month, two-year, five-year and 30-year U.S. Treasury debt.
In normal times, the yield curve slopes up, or “steepens,” with interest rates rising commensurate with the bonds’ maturity dates. This makes intuitive sense, since investors demand—and are normally rewarded for—making longer-term (hence riskier) bets with their money.
When growth starts to slow, the yield curve begins to flatten. That’s where we are today. A two-year Treasury note yields 2.43%, compared to 2.87% for a comparable 10-year note. That’s a difference of only .44%. Meanwhile, the spread between the five-year and 30-year Treasury notes is only .32%, the lowest spread in 11 years. The yield curve is nearly flat, rather than steep.
Figure 1: The normal yield curve, starting to flatten
If the yield for shorter-term bonds goes higher than the yield for longer term bonds, the yield curve becomes inverted.
Figure 2: The inverted yield curve
Now you know what a yield curve is. But why should you care?
Here’s why: Historically, an inverted yield curve has proven to be a powerful signal of looming recession. In fact, it has preceded all of the last nine recessions going back to 1955. However, there have also been instances where an inverted yield curve has not led to a recession, so it’s not a foolproof indicator (no indicator is).
Currently, there is no sign that the yield curve will invert, so you shouldn’t be alarmed. In fact, most economic forecasts rate the possibility of a coming recession as highly unlikely.
The Federal Reserve isn’t terribly concerned, either. Notes from the Fed’s most recent open market meeting peg the chances of the U.S. slipping into a recession by next March at a modest 13.4%.
Nevertheless, the fact that the yield curve is flirting with inversion is certainly worth noting.
To help prepare for your upcoming yield curve conversation starter, take a peek at this Bloomberg article on investors and the inverted yield curve.
Have a wonderful evening.