What is the yield curve and why are people concerned about it?

Posted by

Almost a decade on from the 2008 Financial Crisis, the United States is entering one of the longest periods of continuous economic growth in recent history. While this is good news, investors and policymakers are increasingly asking: how close is the next crisis, and what might cause it? Some observers have pointed to the flattening yield curve and suggested that it may signal a recession is coming. Unfortunately, the issue is often presented in a way that makes it difficult to follow. So what exactly is the yield curve, and why are some people worried about it? Perhaps most importantly, is their worry justified?

The yield curve is a graph that shows how much interest treasury bonds pay, depending on how long the bond lasts. When investors buy bonds, they are making a loan to the bond issuer. A treasury bond is essentially a loan to the United States Treasury, and owning one is owning a small piece of the national debt that the Treasury pays interest on. Under normal conditions, a bond’s yield (the interest rate) should increase as the length of the bond (the maturity) increases. Investors want a higher interest rate for a longer loan because longer loans are riskier—there’s more time for something to go wrong. As such, the yield curve (the graph of yields at different maturities) is normally upward sloping, with the yield increasing as the maturity increases. Thirty-year bonds have higher yield than twenty-year bonds, and so on.

Economists expect this upward-sloping yield curve in normal conditions, but sometimes (like right now) the yield curve is relatively flat: long-term bonds don’t pay much more interest than short-term bonds. The yield curve can also become downward sloping, which is known as an inverted yield curve. This is counterintuitive: in theory, short-term bonds should never pay more interest than long-term bonds, because they are less risky.

How can the yield curve become inverted? When an investor decides to buy an asset, one of the first decisions they make is whether to buy stocks or bonds. In general, Treasury bonds are among the safest bets since the Treasury has a good record of paying back its loans. If an investor expects the stock market to decline, they will probably decide to buy bonds instead of stocks, which won’t seem worth the risk. If a lot of investors expect a recession, they will want to buy bonds, and the rising demand will mean that the Treasury can pay less interest when they issue new bonds.

When interest rates on long-term bonds drop, it means that investors expect a recession in the near future. That drop in long-term bond yields translates to an inverted yield curve and an inverted yield curve has preceded every recession in the past 60 years.

Is a recession on the way? Or is this time different? The answer may be neither. It’s important to note that the yield curve is not currently inverted. It’s flatter than it has been for a while, but it’s still upward sloping. In fact, today’s yield curve looks similar to how it did for most of the mid-1990s, which was one of the longest periods of sustained growth in U.S. history. In some ways, it makes sense for the yield curve to be flatter than usual right now: the Federal Reserve has been raising interest rates, which closely track with short-term Treasury yields. However, long-term Treasury yields (which are outside of the Fed’s control) have remained relatively stable. It’s possible that longer-term bond yields will start to rise as well, or a flatter yield curve may become normal, reflecting the relatively low economic growth of recent years.

It’s probably too early to start worrying about the yield curve. Policymakers do have tools available to make the yield curve steeper, either by holding off on short-term interest rate rises or selling some of the long-term bonds that the Federal Reserve bought during and after the 2008 financial crisis. In Fed Chair Jerome Powell’s House and Senate testimony in mid-July, some members of Congress suggested doing this, but Powell pushed back: holding off on raising interest rate could increase the risk of inflation or unmanaged growth leading to a crash. Steepening the yield curve by trying to increase yields on long-term bonds would make it more expensive for the government to borrow money, increasing the debt over time.

For now, the safest course of action may be simply waiting to see what happens. If the yield curve flattens out even more, it may be worth revisiting these concerns, but for now, it’s too soon to tell. A flattening yield curve shows that the economy is in transition: slow but steady recovery from the financial crisis is turning into steady and slightly less slow growth, with the economy close to full employment. The current economic situation certainly isn’t perfect: stocks are overvalued relative to corporate earnings, the national debt is a continuing problem, and trade disputes could get out of hand. The yield curve, however, shouldn’t be on the list on economic indicators to worry about right now.

To learn more about the yield curve, download “The yield curve: primer and outlook” for key data and takeaways.