Economic experts are starting to warn that a US recession is becoming more likely because of something called the “yield curve.” So what’s the yield curve? What does it show? And why is it bad if it “inverts?” A chart called the “yield curve” has predicted every US recession over the last 50 years. Now it might be predicting another one. Vox visualized the yield curve over the past four decades, to show why it’s so good at predicting recessions, and what it actually means when the curve changes.
In 1980, the U.S. economy went into a recession but that recession could have been predicted if a very specific type of line would have been observed. This line is called the “yield curve.” And that’s why some experts freaked out;
“A recession warning.” “An inverted yield curve.”
It all starts with a US treasury bond. A bond is basically an agreement saying: If you lend the federal government, say, a hundred dollars, they’ll pay you interest while they hold onto your money until the date they agreed to pay you back. And the longer you let the government keep your money, the higher the interest rate.
Next you need to understand that most people don’t buy bonds from the government. They buy and sell them from each other, in the secondary market. And the prices change, based on how much demand there is for a bond. This basically means that the amount of profit you can make on each bond changes every day. Trace these bars on any given day, and you get a curved line, showing the yields of different bonds — or what people call “the yield curve.” And normally, it points upward.
Now here’s where it gets even more complicated. Let’s say you’re an investor… and you have a hunch that an economic downturn is coming, in the near future. If your hunch is correct, that means that if you buy a two-year bond, you might get your money back in a bad economy, and there might not be anything good to re-invest in. That makes a two-year bond a lot less attractive to you. And if lots of other people think this way, then the demand for two-year bonds plummets. So they start selling for cheaper.
But because the two-year bond now costs less, it yields a better return, relative to that low cost. And at the same time, investors who think a downturn is coming might think, I’d rather invest in a 10-year bond that pays out way later — when I think the economic downturn will be over. So that bond gets more popular. But it also gets more expensive. So investors start yielding less money. And if enough investors are acting on this expectation, the yield on a long-term bond, which is almost always higher than on a short-term bond, can actually dip lower. And if you draw that yield curve, you can see it goes in the other direction. It inverts.
In other words, when this chart looks like this, it means investors think an economic downturn is probably coming in the near future. And that’s what’s happening now. So, is a recession coming? Not necessarily. But when re-design the chart so we can see all the years on a single screen, it’s pretty safe to say: When the yield curve inverts, it’s not a good sign.