In trying to determine if the U.S. economy is headed for a “double dip” recession The Economist has taken a look at the historical impact of the yield curve.
The yield curve is the relationship between a series of fixed income assets yield to maturity and time to maturity. The chart below depicts three basic types of yield curves. A normal yield curve is upward sloping. This means that bond yields generally increase as the maturity increases.
Steep – Large difference between low short- term yields and high long-term yields.
Flat – All maturities have similar yields.
Inverted – Long-term yields are below short- term yields.
The article from The Economist states that the yield curve is sometimes used as a simple economic indicator. Inverted curves have preceded the last seven recessions by 6 to 24 months. As for steep yield curves, like that which exists today, the author states, “What all this tells me is that as long as the yield curve remains relatively steep, it is a powerful inducement to credit creation. Credit is currently contracting, but with time the positive lending spread will recapitalize banks and awaken interest in lending.” This credit creation could occur because banks traditionally pay interest on short term deposits and receive interest on long term loans. A steep curve creates a large spread between interest paid and interest received, thus incentivizing banks to lend.
The slope of the yield curve has not always been a reliable economic indicator, however. Neither an inverted yield curve in 1966 nor a flat yield curve in 1998 was followed by an economic contraction. Also, an economic recession has occurred when the yield curves was steep. This happened during the early 1980s when the only double dip recession in the past 70 years occurred.
For more on the yield curve see the July 1, 2010 Federal Reserve Bank of Cleveland’s Economic Trends online article. Also, in 2006 the Cleveland Fed took a historical look at the yield curve in a short paper titled Does the Yield Curve Signal Recession?