What is the yield curve and what does it mean?

The phrase “yield curve” sounds like wonky Wall Street talk. Fortunately, like many such inside baseball terms, the concept behind it is really pretty simple.

The yield curve is a graph that shows how much investors will receive for buying shorter-term debt compared to longer-term debt of similar quality. It’s important because the shape of the yield curve has been a reliable indicator of whether an economy is headed into a recession.

Here’s what you need to know about the yield curve and what it may mean to you:

The yield curve in normal times

Let’s use something familiar, like certificates of deposit, to explain how the yield curve works.

If you’ve ever looked at rates for these savings vehicles, you’ve no doubt noticed that long-term CDs pay higher interest rates than short-term CDs and traditional savings accounts. Why? The banks needs to give you a little something extra in exchange for keeping your money longer. For example, as of May 17, the average 1-year CD is paying 0.88 percent interest, and the average 5-year CD is paying 1.44 percent, nearly double, according to Bankrate.

The same concept applies throughout the economy, and most critically, in Treasury bonds. These are the instruments the federal government uses to borrow money and the most common debt where the yield curve is used to forecast the direction of the economy.

Here’s what a normal yield curve for U.S. Treasury bonds looked like on May 17, 2018:

Source: U.S. Department of the Treasury

The inverted yield curve

Now, as the ominous Chinese curse states in roughly translated English, “may you live in interesting times.”

Lately, there’s been a lot of talk about the yield curve, and that’s because it’s behaving in unusual ways. In recent months, the Treasury bond curve’s traditional upward slope has flattened, meaning the “extra” interest paid for long-term investors – the so-called “term premium” is disappearing. And for a short while, long-term investors were getting lower rates than short-term investors. That yield curve sloped downward instead of upward – something economists and market watchers call an inversion.

On the surface, this seems crazy. If a bank offered you 4 percent returns on a 3-month CD or 3 percent returns on a 10-year CD, you’d jump at that 4 percent rate, right? Why would anyone tie up their money at a lower rate?

We’ll tell you why: If you think the economy is about to tank and interest rates are about to plummet. For example, if you were worried that CD rates were on the verge of dropping back to 1 percent, as they were during the Great Recession, you’d be smart to lock in that 3 percent rate long-term. Very smart. After all, don’t you wish you could go back in time and purchase 30-year US Treasury bonds at 6 percent or 7 percent, roughly the going rate during the mid-1990s?

This is why observers are concerned that the yield curve inverted early in 2019. Specifically, in March, 3-month Treasurys were paying higher yields than 10-year Treasurys. When investors start pouring money into those longer-term Treasury bonds – which are bought and sold in an aftermarket, similar to the way stocks trade – that suggests they are worried about the economy, and it drives rates down.

A similar inversion happened more recently on May 13, 2019:

Source: U.S. Department of the Treasury

If you were to buy a long-term U.S. bond, you’d expect to earn higher interest than a short-term bond. And if you thought about it, if you bought a medium-term bond, you might expect to earn a rate that’s between the short- and long-term rates. Let’s go back to CDs: Recall an average 1-year CD pays 0.88 percent, a 2-year CD pays a little better, at 0.99 percent, as you’d expect while a 5-year CD yields 1.44 percent. That’s typically how it goes with CDs and Treasury bonds.

If you were to plot these short, medium, and long-term rates that I just described on a graph, you’d get a curved line. That’s what Wall Streeters (and economists) refer to as the yield curve.

And in normal times, the shape of that curve is probably exactly what you imagine – something out of high school algebra class, sloping steadily upward from low rates in the short-term to higher and higher rates for longer terms.

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What does an inverted yield curve mean for the economy?

An inverted yield curve is not only very unusual state of affairs, but it’s a worrisome economic indicator. An inversion between the 3-month and 10-year bonds has preceded every recession on record since 1960, according to the Federal Reserve. In fact, research cited by the Federal Reserve suggests the connection between an inverted yield curve and a dismal economic outlook dates as far back as 1858.

An inverted yield curve is an indicator that a recession might be coming … “might” being the crucial word. The economy is always changing, and there are other potential explanations for this unusual state of affairs.

An economic brief published by the Federal Reserve Bank of Richmond offers hope that this time, things might be different. Maybe, low interest rates are to blame or at least they make inversions less likely predictors of trouble, the paper speculates. Interest rates have been very low for a long time, so there isn’t much difference anyway short and long term Treasurys. So there’s no upward slope for long-term investors. Economists say the yield curve has “flattened.” The Fed paper notes that the term premium averaged 1.6 percent since 1961, but it had dropped all the way to 0.20 percent by 2012. In this new, flatter world, perhaps an occasional dip of the 10-year Treasury below the 3-month Treasury is more likely.

“If the term premium narrows, yield curve inversions will become more likely even if there is no increased risk of recession,” the Fed paper says. “If the term premium continues in that range for the foreseeable future, then yield curve inversions will be much more likely in the future, all else (such as the state of the economy) equal.”

In other words, don’t overreact to news about the yield curve. Past performance is no guarantee of future returns. Still, it is a data point and an important one. As always, it’s best to keep on top of your investments, do your research, talk to professionals, make a wise plan based on sound principles and stick to it.