Quick Explainer Of Yield Curves And Their Economic Predictive Powers:
In this context, “yield” is the interest rate for short and long term U.S. government bonds. Riskier bonds typically have higher yields. Like anything else, higher risk tends to correlate with higher reward/yields.
Short term interest rates are usually lower than long term interest rates since there is typically less risk in the short term than in the long term.
The reason? We are often better at assessing risks in the present to near-future than we are at assessing risks in the far-future. Why? A lot can happen between today and five-years from now that we have no way of predicting.
In times before recessions, the difference between short term and long term interest rates become negligible. Right now, this is where we are.
If long term interest rates drop below short term interest rates, then we are facing an ‘inverted yield curve’. Inverted yield curves defy logical convention, since we usually have better insight into present and/or near-future risks than risks that are far into the far-future.
Inverted yield curves have predicted every single recession since the 1950’s.
Typically, when an economy seems in good health, the rate on the longer-term bonds will be higher than short-term ones. The extra interest is to compensate, in part, for the risk that strong economic growth could set off a broad rise in prices, known as inflation. Lately, though, long-term bond yields have been stubbornly slow to rise — which suggests traders are concerned about long-term growth — even as the economy shows plenty of vitality.
At the same time, the Federal Reserve has been raising short-term rates, so the yield curve has been “flattening.” In other words, the gap between short-term interest rates and long-term rates is shrinking.
The Times reported that as of Thursday, the difference between short- and long-term rates was a paltry 0.34 percentage points.
The last time yield curve hit such levels was in 2007 – just before one of the worst recessions in recent American history.
Should the gap continue closing until the long-term rate is lower than the short-term rate, the yield curve will become inverted:
An inversion is seen as “a powerful signal of recessions,” as the president of the New York Fed,John Williams, said this year, and that’s what everyone is watching for.
Every recession of the past 60 years has been preceded by an inverted yield curve, according to research from the San Francisco Fed. Curve inversions have “correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession,” the bank’s researchers wrote in March.