Historically an inversion of the yield curve has preceded a
recession by about 12 months. So, what is a yield curve? Why does it predict a
recession? What does this have to do with snow sleds? Stay with me for a
minute, and this will make more sense — first a couple of definitions.
Tedious, but necessary background
information - A bond is a fixed income
investment where one party, the investor, loans money to another, the bond
issuer. Bonds are issued for a fixed period of time. The bond issuer may be a
government or a corporation. The bond issuer pays interest to the investor at
predetermined intervals and then returns the principal when the bond matures.
A yield curve is an imaginary line connecting the interest
rates of bonds maturing at different periods. The term or length of the bond is
represented on a number line moving from left to right. Above each point on the
number line is the corresponding yield of bonds maturing in that term. A
typical yield curve slopes up and to the right as the bonds yield increases
with its duration.
Consider a mortgage. The interest rate on a 15-year mortgage
is generally less than on a 30-year mortgage. That is because the lender wants
more compensation for tying up their money for an extended period. The longer
the term of the loan, the higher the possibility that a person may default on
the loan. The same is true for bonds. Generally, bond investors require a
higher yield to commit funds for more extended periods.
The Inversion
- An inversion is where the yield on some shorter-term bonds rises above the
yield on some longer-dated bonds. An inversion signals that some investors feel
there is more economic uncertainty in the near term than farther in the future.
As a result, they require a higher rate of return to invest in bonds maturing
sooner than they need for bonds maturing later. A significant inversion in the
yield curve for some time, signals a substantial number of investors believe a
recession is on the horizon.
The Snow Sled
– What could this have to do with a snow sled? Before a snowstorm, the sale of
sleds increases. The number of sleds sold is an indication of the confidence
people have in the weather forecast. But, the sale of sleds doesn’t dictate the
weather. Weather forecasts change, and people prepare for storms that never
happen.
