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The longer you loaned someone your money, the more you would want to be paid back for the loan, right? After all, going ten years without $100 is tougher on your wallet than going without it for just a month. It would be strange to make more on a loan you gave for a short term rather than a longer period of time.
You can think of the "yield curve" (a leading economic indicator) in similar terms.
What is the Yield Curve?
The yield curve, simply speaking, is based on the interest rate of bonds (yield) over time. A bond is a loan to the government or a corporation. One invests in a bond as a kind of I.O.U. that the government or corporation will pay back the initial sum invested with interest over a set number of months or years.
The interest rate on a bond is typically dictated in relation to the loan term (maturity). The term on these bonds typically ranges from 1 month to 30 years. Generally, a bond's interest rate is higher with longer maturities, as the government or corporations offer a better interest rate to convince investors to lend the money out for longer periods of time.
Thus, the interest rate of a bond typically rises over time. This is the yield curve. On a graph, it looks like this:
Graph source: Money-Zine
As seen above, the interest rate for a short period of time (closest to the left) is less than the interest rate for a long period of time (closest to the right). This is typically how the yield curve work.
What is an Inverted Yield Curve?
When the interest rate on short term bonds rises above the interest rate on long term bonds, that's an inverted yield curve. Here's an example of what that looks like:
Graph source: Investopedia
This is the inversion - instead of rising left to right, the return graph descends over time and is ultimately lower on long term bonds than short term bonds. Now, instead of interest rising with how long your money will be tied up, interest rates actually drop the longer you loan your money.
The Yield Curve as an Economic Indicator
Depending on the yield curve, there are several potential inferences investors make about the equity market. These can all be taken with a grain of salt - after all, no two markets are the same, and past performance is never a foolproof indicator of future happenings. Still, depending on the shape of the curve, historical data points to a few potentially repeatable circumstances.
A flattening yield curve, for instance, is generally understood as an indicator of economic slowdown. Whether it's driven by what investors anticipate will happen, either with inflation or the Fed, or actual economic change is uncertain. After all, if investors believe a slowdown is imminent and cease investing, the slowdown becomes a kind of self-fulfilling prophecy.
An inverted yield curve is thought to herald an oncoming recession. After all, when the yield on bonds with longer maturities falls under the shorter, it would appear that confidence in the stability of the economy is low. This means that investors, believing that a possible recession could result in lower interest rates, will invest in the longer-term bonds to lock in those longer-term yields. This sends the price of the “in demand” longer maturity bonds higher and subsequently lowers the yield. At the same time, bonds with shorter maturities are not in demand, causing their yield to remain flat or increase. Therefore, with the longer-term bond yields declining while short-term rates remain flat or increase, the yield curve can inverts.
Every U.S. recession in the past 60 years was predicted by an inverted yield curve. Despite all this, Matt Yglasias at Vox warns against full-faith in the predictive ability of the inverted curve:
But while the empirical link between past inversion events and recessions is real, it’s also clear if you look at the chart that there’s a time lag involved. That means there’s nothing automatic about this process. And while the theoretical link between recessions and inversions is real, there are also other sets of future financial situations — like a sudden spike in the value of the dollar — that could produce the same result.
This, taken into consideration with the often considerable gap between inversion and recession, seem to say the same thing: proceed with caution, but perhaps not panic. While every recession for the last 60 years has been preceded by an inverted yield curve, not every inverted yield curve has been followed by a recession.
In addition, the gap between inversion and recession can be a year or more. Sometimes as long as three years. In fact, according to an analysis by Bespoke Investment Group, the S&P 500 has gained at least 9% one year after inversions since 1978 and gained more than 14% from inversion on August 19, 2006 and the start of the Financial Crisis in the fourth quarter, 2009.
Hopefully, with a little prudence and a discerning eye on the market, all will be well over time.