The yield curve is a graph of interest rate levels across all the various maturities, from the overnight federal funds rate to the 10-year Treasury note. Normally this curve slopes upward, showing long-term rates that are greater than short-term rates. An inverted yield curve occurs when short rates become higher than long rates.
Why is that ominous? Because the current 4.25% federal funds is right now a hair's breadth away from the 4.37% yield on 10-year Treasuries, with further Fed rate hikes likely, and an inverted yield curve has preceded the last five recessions. Historically, this upside-down rate pattern has meant that the bond market expects the Fed at some point in the not-too-distant future to start cutting interest rates to shore up a weakening economy. That would be one explanation of why bond yields are so low right now, despite the Fed's 13 quarter-point rate hikes in the past year and a half.However, many economists believe that the yield curve no longer sends the same message. Edward Yardeni at Oak Associates, for one, says financial deregulation, which in 1986 abolished interest rate ceilings that savings banks could pay on deposits, is the biggest difference. Before deregulation, as the Fed jacked up short-term rates, money for mortgages and other loans would dry up as investors sought higher yields outside the banking system. Credit crunches and recessions followed.
Now, however, the message in the yield curve may have changed. "In my opinion, the shape of the yield curve provides more insight into the [bond] market's outlook for inflation than for real economic activity," says Yardeni. Indeed, Greenspan has gone so far as to say that the yield curve is no longer a useful guide to the economy.
Of course, many in the bond market still disagree. But keep in mind that while the yield curve has inverted prior to the past five recessions, it also turned upside down in 1995 and 1998, signaling absolutely nothing. By James C. Cooper