The yield curve is usually upward sloping, where a higher fixed rate of return is earned from lending money for longer periods of time. Shorter-term yields tend to represent what investors believe will happen to central bank policies in the near future. Longer-dated maturities represent investors’ best guess at where inflation, growth and interest rates are headed over the medium to long term.
However, when an economy is slowing, and inflation expectations decline, yields on 10- and 30-year bonds typically fall towards those of shorter maturities, such as three-month and two-year notes as bond buyers bet there is less need for central banks to raise borrowing costs in the future; instead they may need to encourage spending.
This so-called flattening in the yield curve can at some point become a recessionary signal, in particular if the curve becomes downward-sloping or inverted, as happened last week. An “inversion” of the yield curve has preceded every US recession for the past half century.
There are two possible explanations for this predictive power. One is that trading in the $23tn US government bond market serves as a kind of early warning system, identifying approaching dangers that individual forecasters struggle to spot. The other is that shifts in the shape of the yield curve play an active role in triggering downturns by undermining confidence in the economy.