The "yield curve" is a term used to describe the various interest rates paid by different maturities of fixed-income investments. It's been in the news quite a bit recently, and not in a good way.
Something known as an inverted yield curve occurred this week, and it's happening in a specific way that we haven't seen since just before the Great Recession. That's a period many investors don't remember fondly.
To better understand why this situation has some concerned, here's a primer on what an inverted yield curve is, why it is considered to be a sign of trouble for investors, and what this particular yield curve inversion means to you.
What is an inverted yield curve?
A yield curve refers to the interest rates, or yields, paid by different maturities of similarly rated fixed-income securities. While the term can technically refer to any type of fixed-income investments, it is most often used in reference to Treasury securities. When plotted on a grid, the points for each maturity rate form a line that curves; hence the name.
There are three main types of yield curves -- normal, flat, and inverted.
In a normal yield curve, Treasuries with longer maturity lengths have higher yields. For example, in a normal yield curve, the 2-, 5-, and 10-year Treasuries might yield 2%, 2.5%, and 3%, respectively.
A flat yield curve means that Treasuries of differing maturity lengths have roughly the same yields. If the 2-, 5-, and 10-year Treasuries are all yielding about 3.5%, we'd say that the yield curve is flat. Similarly, if Treasury yields on a normal yield curve all begin to gravitate toward a certain yield, we may say that the yield curve is flattening.
Finally, an inverted yield curve means that shorter-maturity Treasuries have higher yields than longer-maturity varieties. Inversions can happen in a variety of ways, but the 2- and 10-year Treasuries inverting is generally considered the standard form.
Recently, the three-month and 10-year Treasury yields inverted for the first time since mid-2007, as you can see on this chart of Treasury yields from mid-morning on March 26, 2019:
Why do investors care about yield curve inversion?
For some economists, an inverted yield curve is considered a predictor that recession is coming soon. We generally see an inverted yield curve before a recession occurs, although a recession doesn't necessarily occur every time we see a yield curve inversion. It's not a perfect predictor. And when a recession does follow a yield curve inversion, there's no way to predict when the recession will begin, although it's typically within about 18 months if it does happen.
The three-month and 10-year yield inversion we're currently seeing is especially troubling to investors. As mentioned, we haven't seen such an inversion since 2007, and the Great Recession followed soon after.
Should you be worried?
An inverted yield curve isn't a perfect predictor of recessions. In fact, a different part of the yield curve inverted in December, and the market proceeded to rebound sharply as soon as fears subsided. Plus, the 2-year and 10-year yields aren't inverted, and this is often thought of as the main recession-predicting inversion.
Many economists are saying that the current drop in 10-year Treasury yields is due to factors such as global (non-U.S.) economic headwinds like Brexit concerns and the slowdown in China, as well as the dovish Federal Reserve outlook for interest rate hikes. It's not necessarily the result of a serious weakening in U.S. economic fundamentals. Most economists agree that the U.S. economy is slowing, but few are predicting a recession, even after this latest inversion.
The bottom line is to take the current yield curve inversion as just one of several potential economic indicators to watch. It's worth keeping a closer eye on GDP growth, inflation, and unemployment to see if they also indicate trouble. But this inversion is certainly not a reason to panic and adjust your investing plans all on its own.