What the Yield Curve Is and Why It Matters

You may have noticed a lot more talk about the yield curve lately. However, many investors seem unsure of what the yield curve is or what it means. Simply put, the yield curve plots bond yields (generally Treasuries) over the course of varying durations such as the two year, five year, ten year, etc. On a normal yield curve, the yield should increase for longer duration bonds. When the yield curve inverts though, it means that short-duration bonds yield more than long-duration bonds. It suggests the economy may be set to worsen in the not-too-distant future. 

The yield spread measures the difference between two different bond yields. These bonds represent different durations and investors can compare several different bonds to each other.

Many like to compare the 2-year Treasury yield to the 10-year Treasury yield. As the curve expands or grows, the wider the spread is between the two yields. When the spread is under pressure or contracting though, it means that the two yields are closing in on each other. In this scenario, it’s known as a “flattening” yield curve, as the mark approaches zero. Below zero, and it’s known as an “inverted” yield curve.

When the yield curve inverts, it’s often an indicator of a future recession, causing investors to get more defensive moving forward.

Why Yield Curves Invert

The yield curve is flattening right now and it’s not just the 10/2 year spread. In fact, other studies suggest there are more accurate spread-related measurements that investors should be watching. Because the 10-year, 2-year spread is so popular and easy to access though, it remains one of the most watched Treasury spreads in the market.

Some prefer to look at the 2-year vs. the 5-year, while Wells Fargo analysts say the most accurate predictor is the 1-year vs. 10-year. Another study suggests the near-term forward spread is the most accurate. That measures the “difference between the forward rate implied by Treasury bills six quarters from now and the current three-month yield.”

In a perfect word, short-term rates yield less than long-term rates. When times are good, investors aren’t betting that a 10-year Treasury will outperform the S&P 500. That’s why stocks have done so well over the past decade, as the economy continues to expand. When concerns mount though, investors bail on stocks, real estate and other risky assets and go for the safe havens of longer dated Treasuries. That spike in demand causes a decline in yield and allows an asset like the 10-year to yield a similar amount to the 2-year. 

Are We Entering a Recession?

Many investors are wondering if we’re entering a recession, given that the 10-year yields just a few basis points more than the 2-year. Specifically, the 10-year still yields 26 basis points more than the 2-year. Should this figure eventually invert, then the odds of a recession in the next 12 to 24 months increase dramatically. Or rather, the odds increase dramatically in the minds of observant investors.

The situation with the yield curve is a little tricky. Just because the yield curve inverts does not mean a recession is guaranteed to be on the table. In fact, there have been instances in the past — such as 1965 and 1998 — where an inverted 2-year/10-year yield curve did not precede a recession. 

It’s important to note that an inverted yield curve does not cause a recession. However, it tends to precede them more often than not. While not every inversion precedes a recession, every recession has been preceded by an inverted yield curve. 

Think of it like going to the beach. Just because the sun is out, doesn’t mean we’ll get a sunburn. However, every time we’ve been sunburnt, the sun has been out. In this case, the sun is the yield curve and the sunburn is a recession. Each time the sun’s been out (yield curve inverts), we have often been burnt but sometimes avoid it. However, every time we’ve been burnt (entered a recession), the sun has been out (the yield curve has inverted).

Hopefully that explanation helped more than hurt.

So what are the odds? Studies say nine of the last 10 yield inversions were followed by a recession. Others point out that the inverted yield curve misfired twice in the last 60 years. Either way, it’s fairly accurate. We’re not inverted yet but we’ve been on the way for sometime, with the 2-year/10-year spread slowly but surely flattening for roughly 4 years. So be sure to keep an eye on this mark in 2019 and beyond.