Reading Yield Leaves

Much ink has been spilled over the inverted US Treasury yield curve lately, and I’m guilty of adding to the mess in my previous posts. This is a topic that may seem abstract and complicated to some, but it’s actually quite simple.  We’ll clarify the concept in this post for those puzzled by all the yield-talk.

What is a yield curve

A yield curve is a chart that shows market rates (or yields) for interest-bearing securities (like bonds) across different maturities (typically from short-term to long-term). Under normal conditions, we’d expect the curve to show a “term premium” where long-term yields are higher than short-term yields.

For example, we’d expect the yield on a 1-month CD (short-term) to be lower than the yield on a 10-year CD (long-term).  Plotting this on a graph with yield over term would produce a curve that is upward sloping to the right.  The chart below shows a generic example of a normally sloped yield curve using US Treasuries (side note – when people refer to “THE yield curve,” they’re typically referring to the Treasury yield curve).

But sometimes conditions aren’t normal and short-term yields are higher than long-term yields.  This results in a condition where the curve slopes downward to the right.  The curve is upside down or “inverted” (generic example below).

Inverted Yield Curve

Why this matters

Not only is an inversion abnormal, but historically it has been a bad omen because the economy tends to contract following inversions.  The chart below shows the spread (or difference) between 3-month (short-term) and 10-year (long-term) US Treasury yields since 1982. When the spread dips below the zero-line that means the curve inverts. Notice the curve has inverted prior to every recession (shaded grey) on the graph.

Segments of the Treasury curve at the shorter end have been flirting with inversion since 2018, but short-term yields didn’t officially rise above long-term yields until earlier this year.  Now that it’s happened, curve watchers everywhere are sounding recession alarms.

How it actually works

Okay, so we understand what yield curve inversions are and how they happen, but its relationship to the economy may still seem somewhat arbitrary.  Why would the economy fall into recession (or not) just because of where Treasury yields happen to be?

Well, the economy doesn’t always behave according to what Treasury yields do, but there is a real and perfectly logical connection between the two.  It makes sense when we think of Treasury yields as reflecting the economic growth expectations of investors in aggregate (aka the market).

When long-term yields are higher than short-term, the market expects future growth (represented by long-term yields) to be higher than they are currently (short-term yields).  In other words, the upward sloping yield curve reflects market optimism.

On the other hand, when long-term rates are lower than short-term rates, the market expects future growth will be lower than current levels.  That results in a downward sloping, inverted yield curve which reflects market pessimism.

The point is the shape of the yield curve is not arbitrary and reflects the market’s expectations for growth.  That’s why it’s relevant as a recession indicator.

Details and technicalities

Of course, you already knew it wouldn’t be that simple. An inverted yield curve doesn’t necessarily mean recession.  Although it has been a reliable indicator historically, not every inversion in has been followed by a recession.   For example, there were inversions in the 1960s that avoided immediate recessions.

Then, there’s also the more technical issue of which yield curve to look at, yes, there’s more than one! So far, we’ve only considered the 3-mo to 10-yr Treasury yield curve.  However, some argue this curve is flawed because the 3-mo Treasury yield is heavily influenced by the Federal Reserve. In other words, the 3-mo Treasury yield is not a true measure of market yields since it is controlled by the Fed.

For that reason, some prefer to look at the 2-yr to 10-yr Treasury yield curve. The 2-yr yield is not directly controlled by the Fed but is still short-dated enough to reflect short-term yields.  Some believe that makes it a more genuine reflection of the market-determined yield curve.  From that perspective, the yield curve still has not inverted, yet.

The bottom line 

Regardless of which yield curve you prefer, neither is perfect and both have produced false positives before.  As with any indicator, the yield curve is most useful when used with other indicators that can confirm or contradict a trend. And even then, findings are subject to interpretation.  That makes economic forecasting equal parts data science and art of reading tea leaves.

Victor K. Lai, CFA