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The Changing Yield Curve: What Does It Mean?

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There are plenty of things to worry about when it comes to trends in the U.S. economy, and state of the yield curve is one of them. People fear a changing yield curve because an inverted one is a fairly sure sign of an impending recession. A flatter or reversed curve not only hurts lenders but also sends many investors into a panic.

The Yield Curve Concept

When a "normal" yield curve exists, the yield on long-term bonds is higher than those on short-term ones. This makes sense because someone lending money for a longer period would expect to get paid more for assuming that risk.

This is a simple enough concept that is illustrated in the usual rates on certificates of deposits. For example, the interest rate on a 5-year CD is generally higher than the rate on a 1-year CD, which is higher than the rates on a 30-day CD.

It's the same concept with U.S. Treasury bonds, where longer-term (30-year) bond yields are higher than shorter-term (10-year) yields in a typical market. When that curve reverses, it's historically a warning sign of economic trouble.

The Yield Curve Has Just Inverted

The U.S. stock market plunged 800 points on Aug. 14 on news that yields on the 10-year U.S. Treasury bonds fell below the yields on the 2-year bonds for the first time since 2007, just before the start of the Great Recession. On the same day, the yield on the 30-year U.S. Treasury fell to about 2.01 percent, which was a record low.

This inverted yield curve has become one of the benchmark signals of an impending recession. Experts note that the yield curve has inverted about 14 months prior to the start of each of the past nine U.S. recessions.

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What Does the Changing Yield Curve Mean?

Beyond the fact that the yield curve has inverted is the underlying meaning behind it all. Why did this happen? There are several plausible explanations.

According to Morningstar, one of the reasons for this behavior is that the Fed exercises more direct control over the short end of the curve. In other words, as the Fed raises and lowers interest rates, this has a greater impact on short-term bond rates than long-term ones.

What's happening with long-term rates has more to do with investor expectations and the increased negative market sentiment. The stock market has seen multiple sell-offs so far in 2019 and has become increasingly volatile. Inflation expectations remain high, although they have softened a bit from the start of the year.

An inverted yield curve does tend to correlate with periods of economic recession, and this generally means that markets are expecting stagnating growth in the coming months and years. This effect has the potential to hurt lenders' stability and profits.

Another takeaway from this phenomenon is that there will likely be more interest rate cuts from the Fed in the coming months. In July, the Fed made its first rate cut in over a decade. There is now more pressure for additional cuts in 2019 and into next year.