What is the Yield Curve? And What is Scary about an Inverted Yield Curve?
People (and the market) reacted to what is called an inverted yield curve. So what is the yield curve and why do people worry when it becomes inverted?
First, let’s explain the yield curve. This is simply a graph of how much it costs to borrow money versus the length of time you are taking the loan. As you might expect, as the length of time of the loan increases, the risk that it doesn’t pay back increases and therefore the interest rate that is required for someone to give the loan increases (see discussion of risk/return here to understand why return increases when risk increases). So, the yield curve looks something like this.
You’ll see a similar curve for loans or mortgages when you go to get a new mortgage for your house, for example. As the term of the mortgage or loan increases, the interest rate (usually) increases. So, why do people get 25 or 30 year mortgages if the interest rate is higher? They do that simply because the payment is lower when you spread the payment over a longer period (even with the higher interest rate).
So, as long as the cost to borrow increases with time we are in a “normal market condition”. But when the cost to borrow for a longer term is lower than the cost to borrow for a shorter term, the yield curve goes down rather than up and we say it is “inverted”. Something like this.
In the past, inverted yield curves means investors are thinking that the future economic conditions might be worse than today’s so they want to “lock in” their returns by extending the term on their investments. They think the returns in the future will be worse than the returns today. So they are more likely to buy longer term debt. Longer term debt becomes more interesting, more people try to buy it and the price to buy it goes up (lowering the effective interest rate). The opposite holds for shorter term debt (people don’t want it) so the price goes down and the interest rate goes up.
So, in summary, an inverted yield curve means that the market participants are behaving like the future might be worse than today, signaling a recession or a downturn. Whether that actually happens is unknown but people worry as it has been a good predictor in the past.
Here is a graph from Raymond James that shows the difference between the 2 Year and 10 Year Treasury Bills (US Government Debt). This is a bit of an eye chart but notice that normally there is a difference in the two yields (interest rates) – and it can be more than 9% sometimes. That means if you could buy a 2 Year Treasury bill that paid 1%, you could have bought a Treasury Bill at the same time with a 10 Year maturity paying 1+9 = 10%.
But look at what has happened recently. The difference between the two yields has dropped to almost zero. And look at when that last happened – 2008, the last big recession. Uh Oh. That's why people are nervous.