Explainer: What is a yield curve and why does it matter right now?

A key bond market signal - the yield curve - is displaying warning signs, which is usually an indicator of a looming recession. So how worried should we be?

The yield curve refers to the representation on a graph of the yield – or the return investors can expect – on bonds that mature at different times.

For government bonds, the yield curve reflects the short, intermediate and long-term rates of securities issued by the government and it is often used as a visual representation of bond investors’ feelings about risk.

If you understand how to interpret it, Fidelity Investments says, “a yield curve can even be used to help gauge the direction of the economy”.

In early April, the yield, or rate, paid by the 2-year US Treasury note climbed higher than that of the 10-year Treasury note. Since investors normally expect to get a higher rate on longer-dated bonds, as the difference between the two approaches zero, it is called an “inversion” or a “flattening” of the yield curve.

It matters because the difference between the two yields - or the spread - is said to be a reliable predictor of US recessions. Since 1980 there have been four recessions in the US, and all were preceded by an inversion of the 2-year/10-year spread, according to Ron Leven, a Professor of Economics at Duke University.

The 10-year yield at around 3% is currently higher than the 2-year yield at 2.63%. At the start of April, they both hovered around 2.4%, and the 10-year yield dipped below that of the 2-year yield, creating a so-called inversion of the spread.

The metric itself is a reflection of how investors see the outlook. When market participants become more pessimistic, demand for longer-dated bonds increases, driving down the rate they pay on a particular asset.

This year’s inversion of the spread reflected investor concern that the Federal Reserve’s plan to increase US interest rates would put a brake on growth.

The US central bank increased its benchmark interest rate by half a percentage point in April, after a 25 basis point increase in March, as it tries to tame inflation that’s risen to a 40-year high. While the Fed hopes higher interest rates will put a brake on demand for goods and services and bring prices down, it could also hobble the global economy.

The International Monetary Fund revised down its global forecasts in April, saying Russia’s war in Ukraine has set back the global recovery from COVID-19.

Many other economists are pessimistic about the outlook as continued supply chain issues, the invasion of Ukraine, and inflation all threaten growth. Forty-eight per cent of investors say the US will fall into recession next year, according to a Bloomberg Markets Live survey conducted between 29 March and 1 April, and another 20% expect the downturn to happen in 2024.

Even so, economists at the Fed have cautioned against setting too much store in the yield difference as a predictor of recession.

“There is no need to fear the 2-10 spread, or any other spread measure for that matter,” economists Eric C. Engstrom and Steven A. Sharpe wrote in a blog on the Federal Reserve website. “At best, the predictive power of term spreads is a case of ‘reverse causality’.

“That is, term spreads predict recessions because they impound pessimistic - often accurately pessimistic - expectations that market participants have already formed about the economy, and thus an expected cessation in monetary policy tightening.”

They add: “It can only make things worse if investors not only fear the prospect of a recession, but at the same time, are spooked by that fear itself, which is mirrored in inverted term spreads.”