What Is the Yield Curve and Why Does It Matter?

If you’ve been reading financial headlines recently you may have heard experts talk about the yield curve, and for good reason. The yield curve is the percentage-point difference between the rates on short- and long-term government bonds, and it’s been a remarkably good predictor of past recessions. Typically, long-term bond rates are higher than short-term rates (usually 10-year versus two-year). But when short-term bond rates do better, recessions tend to follow. In fact, every recession in the U.S. over the past 60 years has been preceded by a negative term spread, also known as an inverted yield curve. This means the spread between bond rates has fallen below zero because short-term bond rates have surpassed long-term ones.

So should we be concerned that when the yield curve inverts, a recession is coming? We asked Brent Schutte, Northwestern Mutual Wealth Management Company chief investment strategist, about the topic.

Does a yield-curve inversion signal a recession is imminent?

Not always. Even when the yield curve inverts, which historically has served as a recession warning, we note that there is often a time lag between inversion and a recession. If you look back to 1994, the Fed hiked rates aggressively, taking them from 3 percent at the start of the year to 5.5 percent by the end of the year. As a result, the yield curve fell to .085 percentage points to the positive just before 1995 began. The curve stayed largely between 0 and 0.5 percentage points to the positive for the next few years. We all remember how the economy did in the late ‘90s. The curve inverted briefly in 1998 during an emerging market currency crisis, but didn’t actually invert in a more persistent manner until early in 2000, several months before the markets began to fall and more than a year before the recession began in 2001.

So do you think this cycle has more room to run?

I do. In addition to my point about the long cycle, I think you need to look at a couple other factors. First, a number of central banks have been buying long-term (10-year-plus) bonds with the goal of pushing yields lower. That may be distorting the yield curve. Also, three Fed presidents have made comments that make it clear that they’re watching the yield curve closely. In addition, recent economic data, including retail sales and manufacturing numbers, paint a picture of a strong economy.

What are you watching for when it comes to the possibility of a downturn?

Three things tend to happen prior to market downturns and recessions. First, the U.S. economy runs out of slack. The economic data suggest that hasn’t happened yet. Second, inflation rises, and then third, the Fed rushes to raise rates because they believe if they moderate the boom, the bust won’t be so big. While there is some evidence of rising prices, by all indications consumers are shouldering the rising costs. And the Fed appears willing to let the economy run hot and will ease on the side of easy monetary policy.