The Yield Curve

Much of the recent discussion of financial markets has focused on the yield curve and what it signals. In order to understand the theoretical signals it tells us one must first understand what the yield curve is. It is a line of the yields of Treasury debt of different maturities, from the short-term 3-Month T-Bill to the 30-year Treasury Bond. Maturity is when a debt instrument comes due and the creditor reimburses what was borrowed.

The Yield Curve You Me NYC

Financial theory dictates that a normal yield curve is characterized by long-term rates that are higher than short-term rates. This signals that investors expect future economic growth that will result in inflation, so they expect to be compensated with higher yields in the long-term.

The Yield Curve You Me NYC

A flat yield curve is characterized by short-term rates and long-term rates that are about equal. It signals that investors expect little to no economic growth.

The Yield Curve You Me NYC

An inverted yield curve is characterized by short-term rates that are higher than long-term rates. It signals that investors expect a recession is forthcoming.

The Yield Curve You Me NYC

At this moment we are experiencing a flattening yield curve. It is not yet flat but as time passes it is becoming a flat yield curve. Even if it becomes flat, it will need to continue the relative decline of long-term yields compared to short-term yields in order to eventually invert. In my experience, this sign of an upcoming recession does tend to eventually ring true, but it is prudent to look at other common signs and consider the big picture of what is going on in financial markets and economics. To put this all simply, it does not appear a recession is yet likely in the near future. But as time passes more storm clouds appear to be forming over the horizon. So be vigilant.