The interest rates on short-term debt—think 2-year Treasury bills—are typically lower than those on longer-term bonds. That’s because the latter must compensate investors for the relatively increased risk that rates will rise during the longer life of the investment. This phenomenon is expressed by what is known as the yield curve, with interest rates stepping up as bond terms lengthen—à la the teal line in the chart below.
“However, when the Federal Reserve repeatedly raises rates, as it’s been doing for the past two years, the normally upward-sloping yield curve may flatten out or even invert,” explains Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “And that makes many people nervous, because an inverted yield curve has preceded every modern recession.”
Although the Treasury yield curve has flattened considerably during the past eight years (as illustrated by the orange and pink lines, below), it hasn’t yet inverted, which happens when short-term yields actually exceed longer-term ones. However, even if that does occur, it doesn’t automatically augur a recession. In fact, the yield curve has sent a number of false signals, Kathy says—most recently in June 1998, when no recession came to pass despite the curve’s brief inversion.
What’s more, the time between an inversion and a recession is far from consistent—ranging from as few as nine months to as many as 24—even when they do correlate.1
“The yield curve is something to keep an eye on, to be sure,” Kathy says. “But if other economic indicators are strong, it’s not worth losing sleep over.”
1Eric Engstrom and Steven Sharpe, “(Don’t Fear) the Yield Curve,” federalreserve.gov, 06/28/2018.
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