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Recession watch: What is an ‘inverted yield curve’ and why does it matter?

The yield curve has inverted before every U.S. recession since 1955, suggesting to some investors that an economic downturn is coming.

The Dow plunged more than 800 points as investors feared a recession following poor economic data from Germany and China. (Video: Reuters)

Stock markets tanked Wednesday after the bond market sounded a loud warning that the U.S. economy might be headed toward a recession.

Investors are spooked by a scenario known as the “inverted yield curve,” which occurs when the interest rates on short-term bonds are higher than the interest rates paid by long-term bonds. What it means is that people are so worried about the near-term future that they are piling into safer long-term investments.

In a healthy economy, bondholders typically demand to be paid more — or receive a higher “yield” — on longer-term bonds than they do for short-term bonds. That’s because longer term bonds require people to lock their money up for a greater period of time — and investors want to be compensated for that risk. In contrast, bonds that require investors to make shorter time commitments, say for three months, don’t require as much sacrifice and usually pay less.

Just think about the deposits in your bank account, which are in many ways a loan to the bank. You can withdraw that money at any time, so the bank doesn’t pay you a high interest rate. By comparison, if you lock up your money in the bank for a year or longer, you’ll get higher rates. The bond market works similarly: The longer you lend your money, the higher return you’ll get.

For U.S. government securities — known as Treasury bonds — that relationship has now turned upside down. On Wednesday morning, the yield on the 10-year Treasury temporarily fell below the yield on the two-year Treasury for the first time since 2007. (It later recovered slightly.)

The following chart shows the difference in yield between the two-year Treasury bond and Treasury bonds of other duration. Bonds of longer duration should have higher yield, but as you can see, it has dipped below for several longer-term bonds.

Other parts of the yield curve have been inverted for a few months. For instance, three-month Treasurys have been yielding more than 10-year Treasurys since late May. The gap became more dramatic Wednesday, with three-month Treasurys paying nearly 0.4 percentage points more than 10-year Treasurys as of midafternoon, greater than the 0.1 percent difference seen in late May.

The more pronounced inversion is a sign that people are more concerned about the fallout of the trade war between the U.S. and China and worried by signs that economic growth may be slowing around the globe.

Stocks losses deepen as a key recession warning surfaces

So why do investors care?

The yield curve has inverted before every U.S. recession since 1955, although it sometimes happens months or years before the recession starts. Because of that link, substantial and long-lasting inversions of the yield curve are largely viewed as a strong predictor that a downturn is on the way.

Two researchers for the Federal Reserve Bank of San Francisco summed it up in a letter they published last year. “Forecasting future economic developments is a tricky business, but the [yield curve] has a strikingly accurate record for forecasting recessions,” they wrote. “Periods with an inverted yield curve are reliably followed by economic slowdowns and almost always by a recession.”

The fact that people are willing to take such little money for their long-term bonds suggests that they aren’t too worried about inflation, says Brian Rehling, co-head of global fixed income strategy for the Wells Fargo Investment Institute. If they aren’t too worried about inflation, it also suggests that they expect the economy to grow more slowly in the future, he says. Inflation usually picks up when the economy is hot.

“Essentially, investors are saying, ‘We’re worried about economic weakness,’ ” Rehling said.

Banks are paying people to borrow money. That’s alarming news for the global economy.

The yield curve inversion also suggests that investors expect the Federal Reserve to keep cutting short-term interest rates in an effort to boost the economy, Rehling says.

Fed officials cut the benchmark interest rate by 0.25 percentage points last month, the first rate cut since December 2008. Investors are now expecting the Fed to cut rates by another 0.25 percentage points during its next meeting in September.

There are reasons to have hope the economy won’t go into a recession. The labor market is strong, and most people who want a job are able to get one. Consumers are still opening up their wallets, which is lifting economic growth.

Even if the shift in the yield curve is followed by a recession, the slowdown might not happen right away. A look back at previous downturns shows that yields have typically inverted an average of 18 months before the start of the recession.

Andrew Van Dam contributed to this report.