What is a “yield curve inversion” and why have we been hearing about this a lot lately?

Ok, before we start talking about scary stuff like recession, it is important to remember that no economic indicator is a perfect predictor of what’s to come. That being said, it is also important to note that yield curve inversion has historically proven to be pretty accurate in foreseeing recession in the past. Gulp. 

So, what exactly is it?

The yield curve is simply a chart showing the interest rate costs of bonds at various terms. So, how much does a bond cost at 1 year, 3 years, 10 years, etc. The “curve” is just the line drawn between these points on the graph. The yield curve is just a picture of how much debt can cost.

Typically, the longer the term, the more the debt costs. This makes sense. People buying the debt are taking more risk the longer the principal is unpaid and want a greater return. So, generally, the curve moves up the further to the right you go on the picture. 

A yield curve inversion is when the longer-term debts are priced less expensively than the shorter ones. The typical comparison used is between the 2-year rate and the 10-year rate. As of the day of this writing, the 10-year is just a hair below the 2-year. 

Why does this indicate recession? It means that the bond buyers think that there is more risk in investing in the short term than in the long term and therefore want a greater reward. When you think about the risks involved in long term investing – all the unknowns of what the world will look like in 10 years – the fact that bond buyers think there is more risk in the short term can really only be brought on by one thing: they are predicting a recession. Unfortunately, they have been pretty accurate in their predictions.

More bad news. When inflation and a stagnant economy come together at the same time, the goofy description of “stagflation” is used – a term many of us remember from the 1970s. 

There is, maybe, some good news. While many pundits predict the recession will come late this year, or early next year, they also predict that it will be a quick recession. This stagflation should not be as long lived as it was in the 1970’s. Even though rate increases are definitely on the way, and a recession is probably coming, the fundamentals of the economy are quite a bit different now than they were back then. Right now, we have low unemployment, wages are increasing and there is still a lot of pent-up consumer demand. And while the yield curve inversion can predict a recession, it can’t give us any information about length or severity. There will be some turbulence, but the plane should land just fine. But I’d probably still buckle up and put my seat in the upright position.