YOU DECIDE: Should you follow the 'yield curve?'
Here's a question: What has economists all worked up and excited? Is it the upcoming NFL playoffs, the new King Kong movie, the start of conference basketball or the “yield curve?” You're smart enough to see this is a trick question, and yes, the answer is the yield curve.
The yield curve is the hot topic in economic discussions and on financial Web sites.
Let me quickly say this isn't because economists don't care about sports and movies. In fact, most of us do. But the current state of the yield curve is so unusual that it's really trumping our interest in who wins the Super Bowl or goes to the Final Four. And although I don't expect most of you to share the same passion for the yield curve, I will argue you should pay attention to it, especially today.
OK, OK, you might be thinking, please tell me, what is the yield curve? The yield curve simply shows the relationship between short-term interest rates and long-term interest rates. Usually, short-term rates are lower than long-term rates. For example, the interest rate earned on a 3-month CD (certificate of deposit) will be lower than the rate on a 5-year CD, or the interest rate paid on a 12-month loan will be lower than the rate charged on a 60-month loan.
The major factor behind the higher interest rate for longer term loans or investments is risk. More can go wrong the longer money is outstanding, and so investors demand and lenders charge a higher rate as compensation.
So the interest rate typically rises as the time period of the investment or loan increases. This rise in the interest rate, or “yield” as some call it, suggests a “curve” that moves up with time. Thus, the ordinary yield curve looks like a rising hill.
What has the attention of economists is that the yield curve today doesn't look like a rising hill; instead, it looks like a flat line. Short-term and long-term interest rates are very similar.
And, with the Fed pushing up short-term interest rates, there's the very real possibility the yield curve could switch from a flat line to a falling ski slope, meaning short-term rates would be higher than long-term ones. In fact, by some alternative measures of the yield curve, it has already turned into a ski slope.
Enough, already! What does it matter if the pattern of interest rates is a hill, a flat line, or a ski slope? Well, it matters a lot because the shape of the yield curve has traditionally been a very good predictor of the performance of the economy.
When the yield curve has the normal shape of a rising hill, it's a good sign an improving economy is in our future. If the curve becomes a flat line, this is a signal the pace of the economy will slow, although growth will still occur.
Yet the biggest eyebrow raiser happens if the yield curve looks like a ski slope (an "inverted" yield curve, to use technical language). In the past, this has been an excellent forecaster of a recession within the next 18 months. This should get your attention!
Now, some economists say the predictive power of the yield curve has outlived its usefulness. They say the globalization of the financial markets makes the meanings of the various shapes of the yield curve different today than in the past. So, argue these analysts, a flat or ski slope yield curve isn't necessarily bad news.
On the other hand, why take a chance? The yield curve has had a good track record of calling the economy in the past, and it still might. So maybe an occasional glance at the latest shape of the yield curve in a financial newspaper might be worth a few minutes of your time. You decide.
Dr. Mike Walden is a William Neal Reynolds Professor and extension