The Yield Curve

The “yield curve” has recently been receiving some attention because it can be a harbinger of economic downturns and has long been analyzed as a tool for predicting recessions. However, I don’t currently see it as a major cause for concern. Here’s why.

Also called the “term spread,” the yield curve is the difference between short-term interest rates and long-term interest rates (such as between two-year and 10-year treasury notes). Typically, long-term interest rates are higher than short-term interest rates, reflecting the fact that there are simply more unknowns in the future and a higher rate is needed to compensate for risk. For example, there is some chance that strong economic growth could set off inflation and negatively affect real returns at some point in the future.

An “inverted” yield curve means that short-term interest rates are higher than long-term interest rates, which would imply that bond traders see softening in the economy. Over the past 60 years, every time there was an inverted yield curve, an economic slowdown followed; in fact, every time but one there was an actual recession. The converse is not true; every slowdown has not been preceded by an inverted yield curve. Nonetheless, it is a pretty compelling indicator that is widely followed.

The spread between interest rates has been generally narrowing for a while now. Part of the reason is that the Federal Reserve has been raising short-term rates, but the fear is that the flattening will become an inversion. An inversion doesn’t cause a slowdown or recession. It’s purely a signal, albeit a fairly accurate one.

If the yield curve does invert, there will be many adjusting their decisions based on past experience. and many pundits will no doubt rush to write about the possibility of a recession. To some extent, it can be somewhat self-fulfilling. If many people across the economy believe there will be a recession and scale back purchases and investments and raise savings accordingly, it can have a dampening effect on the economy.

There is a very legitimate case to be made that the current situation is different from the past in that interest rates are low by historical standards. Lower long-term rates may be more a reflection of a fundamental shift toward lower rates in general than a sign that economic weakness is around the corner.

As I write this, the spread has been widening slightly, so an inversion may yet be avoided. Moreover, while there is no question that the yield curve is a powerful signal, the types of things that typically cause a recession do not seem to be in place at the moment. It’s certainly a cause for watching, but not obsessing.