If you have been reading any business news lately, you have probably been hearing a lot of excitement about something called the yield curve. So what is all the excitement? Most people have trouble understanding why anyone would get excited about an economic concept whose acquaintance is pretty much limited to those who have studied money and banking. The excitement around the yield curve is because for the first time since 2007 the interest rates (or yields) on 10-year treasury notes have fallen below those of two-year notes. According to many analysts, this means we are headed for a recession and the threat of a recession is something that can concern us all. So, what is the yield curve and why is it worth watching?
The yield curve simply shows short-term interest rates compared to medium and long-term interest rates. We call this "the term structure of interest rates." In other words, it shows interest rates (or yields) over the length of the debt. For example, October 1, rates on US Treasury notes are as follows: 6 month=1.81%, 1 year=1.75%, 5 year=1.51%, 10 year=1.65%, 20 year=1.93%.
Interest rates are the price of money, and like any price, they contain much useful information. They are helpful in understanding the current demand and supply of money and the health of the economy along with its likely future course. Typically, we expect long-term rates to be higher than short-term rates because long-term rates have more risk built into them. The increased risk requires higher interest rates as compensation. Even the safest bonds like government bonds have future risk because of the uncertainty about upcoming inflation and future interest rates. There is more possibility of unexpected changes farther in the future than near term so we demand that future interest rates are higher to cover that additional risk.
Why would short-term rates move higher than long-term rates? When the overall growth rate of an economy slows down, it causes strain on businesses, and increases the risk that businesses might not be able to meet their short-term financial obligations. This increased risk of default earns higher interest rates because as investors look at placing their money into companies they will require higher short-term returns if they see an increased possibility of default.
While short-term interest rates are normally expected to be lower than long-term interest rates, if there is enough trouble in the economy, investors might require very high short-term rates. When short-term rates move higher than long-term rates, it tells us that possibly, investors are very worried about short-term economic performance and it becomes news. We call this an inverted yield curve. An inverted yield curve is a valuable forecasting tool because it tells us that investors see an economic slowdown coming.
History has shown a very strong relationship between inverted yield curves and recession. Many statistical studies back up this relationship. The last inverted yield curve was in 2007 and we know that the "great recession" followed in 2008 and 2009. In fact, the statistical studies show that a recession will follow about one year after the yield curve inverts. For this reason, many economists are very worried about a recession next year.
I would warn - not so fast. While there may be many reasons to worry about the economy next year, I don't believe that the inverted yield curve is one of them. Because of many changes, the standard signals from the yield curve are being influenced by other things, and in today's economy may no longer forecast a recession as strongly. The standard argument about an inverted yield curve is that short-term rates indicate investors' concern, but I would argue that the yield curve today is inverted for a different reason - it is because long-term rates have been bid down so much that they have left short-term rates above them!
The things I would mention that have driven long-term rates down are, the growth of shadow banking, the greater connected international economy, and negative interest rates in Japan and Europe. These all impact the demand for long-term bonds. Shadow banking is huge; today non-bank lenders hold more total assets than traditional banks do. The shadow banking repo market demands long-term U.S. debt as collateral. That along with the fact that the dollar is the international reserve currency and because of negative interest rates in Japan and Europe, there is a relentless demand for long-term U.S. treasury bonds.
This unyielding demand has driven up the price of long-term U.S. bonds, which means the interest rates go down. I believe these new situations are causing the current inverted yield curve. However, aside from the yield curve there are other significant issues out there which could cause us near term economic concerns. Our economy could be negatively influenced by the trade wars, the slowing world economy, the election and conflict in the Middle East. Rather than depend on the yield curve's forecast we need to carefully watch a wide variety of indicators in our rapidly changing world in order to effectively understand what the economy might do next year.