The yield curve and what it says about the economy
The U.S. Treasury yield curve has now been inverted for more than a month — meaning the 3-month bill is paying a higher interest rate than the 10-year note.
Why it matters: An inversion of Treasury bond yields is a near-perfect recession indicator that economists at the Federal Reserve recently called "the best summary measure" for an economic downturn.
How it works: Investors demand higher payment for loaning out money for longer periods of time. Bonds are essentially loans, so it follows that a bond that does not return a lender's cash for 10 years would pay more than one that returns the cash in 3 months.
- An inversion of the Treasury curve means the exact opposite is happening. Either investors see a higher chance they'll get paid back in 10 years than in 3 months by the U.S. government (the world's most secure borrower), or they see inflation being so flat that money invested today will be worth a little less in 10 years than it is worth in 3 months.
- Neither says positive things about the market's view of the economy.
- The yield curve inverted in March and in May, but for very short periods of time, and other parts of the curve inverted as far back as December.
Yes, but: It's not time to put money under the mattress just yet. Many market watchers, including top economists and some of the world's biggest asset managers, believe that the extraordinary measures the Fed took after the Great Recession have fundamentally altered the market and things are different this time.
- However, many of them said things were different when the yield curve inverted in 2000 and 2006, too.
There is a bright spot: An inversion doesn't signal a recession is coming immediately. Typically, it takes 6 to 24 months after an inversion for a recession to begin, and stocks perform well.