What is the yield curve

The yield curve is just a graph showing the relationship between short term and long term interest rates of U.S. Treasury notes. Usually the short term rate is lower than the long term one. But if you are lending money to the federal government, which is essentially what happens when you buy a Treasury note, you are taking a bigger risk by letting the government have your money for a longer period of time. So you're going to want a higher interest rate to compensate you for taking on that risk.

But sometimes this relationship changes if the two rates start getting closer together that's called a flattening yield curve. If the long term rate dips below the short term rate, that's what we call an inverted yield curve. And the market is concerned about it. Investors waking up this morning to a recession warning from the bond markets The Dow plunging more than 800 points, sparked by a key economic indicator faltering A brutal day on Wall Street.

Stocks plunging as a yield curve inverted, sparking fears that a recession could be on its way The yield curves predictive power has made it a crucial metric for investors and policymakers alike. The reason why we watch the yield curve so closely is that it has been an incredibly accurate predictor of recessions. Every time that that yield curve has inverted, the economy eventually has gone into a recession. You can see that predictive power on this chart.

It shows a difference between the long term ten year and short term three month treasury rates. When that line goes below zero, it represents an inversion and those inversions have preceded every single U.S. recession going back 50 years. But it wasn't until the 1980s when policymakers started to catch on. Back in the late 80s, the yield curve was being referred to as a possible leading indicator of the economy and I was asked by my bosses whether there was anything to this whether you could prove statistically that there was a relationship.

Arturo Estrella is one of the economists who helped discover the predictive power of the yield curve while working with a colleague at the Federal Reserve Bank of New York. By early 1989, we were not only seeing the predictive power in general using historical data, but we actually saw an inversion. So at that point, it seemed to be indicating that there would be a recession about a year later. And our presentations were met with a lot of skepticism, but the recession started in 1990.

So it was almost the perfect prediction. Many still doubted the yield curve, predictive power. But Estrella's model then successfully predicted the recession in 2001 before the dot com bubble burst. The worst day ever on Wall Street. All the major indices are now down for the year. And perhaps most notably, after a 2006 yield curve inversion, his model accurately predicted the 2007 downturn that became the Great Recession.

Lehman here is going bankrupt. Some of the biggest names in American business are tonight gone, along with a lot of money and a lot of jobs. Estrella's work focused on the difference between the three month and 10 year interest rates. But many in the finance world also watch the difference between the 2 year and 10 year rates closely. The New York Fed research focused on a three month ten year. They feel that that has the most predictive power.

I think a lot of the Wall Street guys that you talk to will tell you that they don't start to get excited about it until a 2 year and a 10 year inverts. The broad principles are pretty similar between both metrics.