You’ve seen and heard endless reporting about the “inverted” yield curve and how it’s a top recession indicator. What exactly does that mean?
The yield curve is just a matter of connecting the dots on a chart, which represents particular yields on bonds of particular maturities. For example, right now the 10-year Treasury note has a yield-to-maturity of 2.007% and the 30-year bond has a yield-to-maturity of 2.533%. If you draw a line between those two yields, you get a curve that slopes upward from left to right as you move to longer maturities.
Normally, the entire yield curve slopes upward from left to right as you move out from 3-month bills to 30-year bonds. That makes sense because longer maturities have more risk of losing money due to inflation or default so they deserve a higher yield (what’s called the “risk premium”). There’s just one problem – that upward slope is not true today.
The 3-month bill yields 2.101%, but the 5-year note yields 1.768%. That means the yield curve slopes down from 3-months to 5-years before sloping up again to the 10-year maturity and beyond. That dip in the curve from 3-months to 5-years is called an “inverted” yield curve because yields drop instead of rising.
An inverted yield curve is considered a sign of recession because the market is saying the Fed may have to raise rates in the short run (to cool off the economy) but longer run rates will be lower (once the recession hits). But that analysis is unlikely to be true today because the Fed has distorted and manipulated the entire yield curve with its QE and QT policies.
It’s hard to know how to interpret the yield curve today except to say the Fed has messed it up and should stop its manipulation. Is the yield curve telling us anything else? According to this article, the answer is an emphatic yes.
In addition to inverting, the yield curve is now steepening. This doesn’t mean all rates are going up. It means the “spread” or difference between short-term and long-term rates is expanding. That can be bullish (investors expect growth and higher rates) or bearish (investors expect recession and are running for safe-haven assets).
We’ll find out soon enough. For now, the inversion plus steepening is being taken by some as a sure sign of recession.
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