Is It Time To Worry About the Yield Curve?

SMITH BRAIN TRUST – Unemployment is at an 18-year low. And the stock market has been strong. But the U.S. treasury yield curve has economists and market watchers feeling uneasy and warning that a recession may be on the horizon.

“Historically, when short-term interest rates are higher than long-term interest rates, a recession has occurred within a few months,” says William Longbrake, executive in residence in the finance department at the University of Maryland’s Robert H. Smith School of Business.

That’s why so many people now are watching every move of those short-term and long-term interest rates.

The yield curve plots the variations in interest rates from the short-term U.S. government securities to the long-term ones. It reveals roughly how expensive it is for the federal government to borrow from investors.

Normally, the longer the term, the larger the interest rate is to compensate investors for risks of investing longer term. Except when it isn’t.

And when it isn’t — when the yield flattens as it has recently and the long-term rates are merely a troubling echo of the short-term ones — the risk of an inversion increases. Such inversions have a habit of portending a coming recession.

Every recession for the past six decades has begun this way, with a flattening yield curve that eventually inverts. In other words, the curve eventually shows short-term government bonds drawing a higher yield than long-term ones.

In a recent trading session, the gap between short-term and long-term interest rates narrowed to just 35 basis points. The last time it was so narrow was in 2007, in the lead-up to the most catastrophic U.S. recession since the 1930s.

“But, perhaps it’s different this time,” Longbrake says. “The Fed has bought a lot of long-term government bonds and this might have depressed long-term interest rates, which would mean yield curve inversion could be a less reliable predictor of recession.”

Nevertheless, many are worried.