The Yield Curve Explained

Early December headlines were scattered with news of the inversion of the yield curve. Under normal circumstances, the yield curve arcs upward because bond investors expect to be compensated more for taking on additional risks owning bonds with longer maturities. So, a 30-year bond will typically yield more than a 3-year note. An inverted yield curve occurs when short term maturities yield more than long term maturities. Over time, an inversion in the yield curve has led to a market downturn; however, as JP Morgan points out in the excerpt below, the inversion in the yield curve may not have the same historical significance it once had.

“Last week, the topic of the yield curve came back to the forefront, as parts of the yield curve inverted and the spread between 2-year and 10-year yields fell to the lowest level this expansion. Investors tend to fear yield curve inversion, looking at it as a signal that a recession is looming. However, we believe investors should not overreact to these recent moves for a few reasons. First, a flattening of the yield curve is common during rate hiking cycles, which is where we are today. Second, this time around, the shape of the curve has been distorted by central bank asset purchases around the world, making it a less trustworthy predictor of recession. Lastly, the curve can stay flat for a long period of time before inverting, and even then a recession can take a while to arrive.

Over the last 7 recessions, it has taken an average of 20 months between the first inversion of the curve and the start of a recession. However, that masks big differences, with it taking 51 months in the 60s to only 8 months in the 70s. As a result, investors should watch other market and economic indicators in addition to the yield curve in order to form an opinion about the business cycle. We believe that while growth is likely to moderate back to its trend pace next year, the near-term odds of a recession remain low.”

Important Note: This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. The opinions expressed herein are those of the named advisors at the time written. Actual economic or market events may turn out differently than as presented. © 2018 Madison Wealth Management