Investors and economists often refer to the yield curve when making forecasts about the direction of the economy. What exactly do they mean?
The yield curve basically is a snapshot of the yields, or expected rates of return, on a collection of bonds of different maturities. The “curve” is the line you could plot connecting those yields.
In a normal yield curve, shorter-maturity bonds offer lower yields, while longer-maturity bonds offer higher yields. This is because investors typically require extra returns in exchange for locking their money up over longer periods—the longer the investment, the higher the risk and, therefore, the higher the expected return. Drawing a line between the different yields in a normal yield curve would result in a rising slope as you move from the short to the long maturities.
The shape of the curve can change as yields fluctuate in response to shifting economic conditions. For example, if the economy is growing strongly, investors might grow concerned about inflation picking up in the future. Because inflation eats away at the value of investment returns, investors might start to avoid longer-term bonds. That decreased demand could cause yields on longer-term bonds to rise (prices and yields move in opposite directions). As a result, the yield curve would steepen.
If inflation does start to pick up, the Federal Reserve could raise interest rates to bring prices back under control. As concerns about inflation fade, the yield curve would flatten.
If the Fed pushes interest rates up to the point where they start to choke off economic growth, investors might start to worry about a recession. If they expect the Fed to start cutting interest rates to get the economy moving again, investors could abandon shorter-maturity bonds in favor of longer-maturity ones in a bid to lock in a higher rate before the cuts start. That extra demand for longer-term bonds would cause their yields to fall.
When long-term yields fall below shorter-term ones, the yield curve is said to be “inverted.” Some market observers see an inverted yield curve as a sign of investor pessimism about the economy. In fact, every recession in the last 50 years has been preceded by an inverted yield curve.
So how has the curve looked recently?
Kathy Jones, Senior Vice President, Chief Fixed Income Strategist at the Schwab Center for Financial Research, says that after briefly steepening earlier this year—possibly reflecting expectations that growth might accelerate—the yield curve began to flatten again.
As of late September, the curve was consistent with market expectations of fairly tame inflation coupled with a gradual rise in both growth and interest rates in the months ahead.