What is the yield curve -- and why it matters

Posted August 14, 2019 8:00 a.m. EDT

— The bond market is flashing a big neon caution sign.

Yields on 2-year US Treasury bonds dipped below the yield on the US 10-year bond Wednesday morning. It was the first time the 10-year yield was below the 2-year yield since 2007 — just before the Great Recession. Both were hovering around 1.62%.

In another worrisome sign, the yield on the 30-Year US Treasury fell to a record low Wednesday of about 2.06%.

This is significant. When shorter-term rates are higher than longer-term bond yields, that is known as an inverted yield curve. The 3-month US Treasury already inverted versus the 10-year this spring. Yield curve inversions have often preceded recessions and are a sign of just how nervous investors are about the immediate outlook for the economy. They are demanding higher rates for short-term loans, which is not normal.

Typically, investors expect to get paid a higher rate of return when they are lending money for a longer period of time, because the risks are higher.

"Historically speaking, the inversion of that benchmark yield curve measure means that we now must expect a recession anywhere from six-to-18 months from today," said Tom Essaye, founder of The Sevens Report, an investment research firm, in a note to clients Wednesday.

The plunge in longer-term yields like the 30-Year are also a symptom of investor anxiety. Bond yields fall in the opposite direction of prices. In other words, they tumble when investors are buying bonds.

So investors have continued to plow into bonds even though they are being promised a miniscule rate of return — or in the case of certain bonds in other big developed markets, no return at all. Long-term yields are negative in Japan and Germany.

Worries about the global economy's slowdown have stoked renewed fears of a downturn in the United States, particularly in light of the trade war with China.

Stock market futures plunged Wednesday morning following the yield curve inversion, setting Wall Street up for a sour session just one day after a truce in the trade skirmish led to a massive market rally.

President Trump said Tuesday that he was delaying tariffs on certain consumer goods — such as electronics, toys and sneakers — so that US consumers would not be hurt by higher prices during the holiday shopping season.

That's a sign that the US consumer may be on edge — and it's clear that investors are nervous about the outlook for the US economy as well.