The inverted yield curve has been in the news lately for good reason; it is the only economic indicator that has a perfect track record for predicting a recession.
A generally steepening yield curve means that investors have strong expectations about economic activity. A flattening yield curve means the opposite, and that’s where we find ourselves today, according to Virtus Investment Partners. Short-term rates are soaring as traders brace for a number of rate hikes this year. Longer-term rates are not rising as quickly, perhaps signaling that investors expect higher rates to slow the economy.
The indicator is observed when short-term rates are higher than long-term rates, and each time this has happened since 1955, the economy has entered a recession between six and 24 months later, according to Virtus.
“In addition to simple signaling, the shape of the yield curve has real-world implications. Rising short-term rates make it more expensive for people to borrow money, whether for a loan mortgage or small business loan or whatever,” Virtus wrote in an overview. “The compounding problems, at least in theory, are that when the curve flattens, banks, which borrow short and lend long , see their margins squeezed and may be less willing to extend credit.”
The current shape of the yield curve, however, is a signal of what investors already know: inflation is too high and growth will moderate.
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