The yield curve has appeared in quite a few news headlines recently. Why is this technical-sounding tidbit of financial jargon suddenly getting so much attention?
The short answer is that the yield curve has a reputation for predicting recessions, and some market watchers are worried recent changes to the curve’s shape are sending a warning signal about the economy.
Are they right? Let’s take a closer look.
What’s in the curve?
The yield curve is basically a snapshot of the yields on a collection of bonds of different maturities, from the very short to the very long. The “curve” is the line you could plot connecting those yields.
Normally, the yield curve slopes upward from the shorter maturities to the longer ones, because short-term bonds usually offer lower yields than longer-term ones. Why? Investors usually require some extra return in exchange for agreeing to tie their money up for longer periods.
The shape of the curve can change as yields fluctuate in response to economic conditions. In general, the Federal Reserve’s interest rate decisions influence the short end of the curve—that is, the yield on securities with short-term maturities. The longer end of the curve is more a reflection of investors’ expectations about the future course of Fed policy, plus expectations about inflation and economic growth.
When the economy is going strong, the yield curve tends to steepen as investors grow concerned about inflation and potential interest rate hikes by the Fed, and require higher yields from longer-term bonds to compensate.
When the Fed raises interest rates, short-term yields rise relative to long-term yields as inflation expectations ease. That makes the yield curve flatten—in other words, the difference between short- and long-term rates shrinks.
However, if the Fed raises rates too quickly, causing short-term yields to rise above long-term yields, then the yield curve can invert. That’s when investors start worrying about a potential recession.