SOLVED: Simple Explanation of The Yield Curve and Why it Matters To You

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The “Yield Curve” is nothing more than a line between the dots on a graph of interest rates.  At the start of the graph (on the left) is very short term interest rates and at the end of the graph (on the right side) is longer term interest rates.

Normal Yield Curve vs Inverted Yield Curve

When long term interest rates are lower than short term rates it means business is expected to DECREASE over time.  When the graph trends down, it is called an “inverted yield curve”

To be clear, the technical definition of an inverted yield curve is a 10 year interest rate that is lower than the the 2 year interest rate (aka. 2s vs 10s).

How Often Does An Inverted Yield Curve Predict a Recession?

If business decreases for more than 3 months in a row, economists call it a recession and that means :

  • businesses stop investing and growing because sales are declining
  • jobs are lost
  • elections typically see the incumbents replaced

Recessions happen for many reasons and are very hard to accurately predict but there is one metric that precedes most recessions, an inverted yield curve.  Since 1956 all previous recessions have hit about 15 months after the yield curve inversions.

yield curve interest rates and recessions in the US

A very big problem with recessions is that, like a run on a bank, they occur whenever people THINK they will occur.  They are a self fulfilling prophecy.  That is not to say that a recession is absolutely guaranteed but in today’s data driven world, the yield curve is taken very seriously.  That is why stock markets ALWAYS tumble when the yield curve inverts:

  • investors get scared and sell their some of their stocks
  • driving the price of those stocks down
  • causing companies and citizens to THINK something is wrong and start holding off on discretionary purchases
  • which further causes demand / sales to drop
  • which causes a recessionary loop

How Likely Is a Recession Likely in 2020?

Merrill Lynch answers this question nicely when last week they said:

“S&P 500 (is) on borrowed time if the 2s10s yield curve inverts,”  SOURCE

and that just happened today.

What Other Factors Are There To Consider When Predicting A Recession?

The US economy is has been expanding for the last 11 years an the average expansion is about a decade, meaning that we are overdue for a recession.

Anything that causes notable uncertainty can cause companies to stop expanding and that will cause a recession.  In today’s world:

 

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