What Is The Yield Curve? Why Is It Important?

The yield curve is often portrayed as one of the most reliable indicators of the economy’s future direction. Why is this the case? More importantly, what can and can’t it tell us?

What Is The Yield Curve? Why Is It Important? 1

The shape of the yield curve gives us important indications of what the future holds for the economy

The mainstream media has been focused on whether or not the US yield curve indicates a looming recession, which implies that what they want to know is whether or not a recession will occur.

To them, it is a binary outcome: recession = bad for markets, and no recession = good for markets.

Unfortunately reality isn’t so simple.

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What Is The Yield Curve? Why Is It Important? 2

The shape of the yield curve gives us important indications of what the future holds for the economy

Before we can answer why the yield curve doesn’t indicate how serious a future recession could be, we need to first understand what the shape of the curve represents.

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What Is The Yield Curve? Why Is It Important? 3

The shape of the yield curve gives us important indications of what the future holds for the economy

When times aren’t “normal” (like now), the shape of the yield curve changes, which is why it is so closely watched by market participants.

How and why does it change?

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What Is The Yield Curve? Why Is It Important? 4

The shape of the yield curve gives us important indications of what the future holds for the economy

Let’s look at this from the simplest of perspectives.

Ignore, for the moment, that the yield curve we’ve been referring to is that of UST yields. Instead, just think of yields as interest rates in the most basic sense – how much a business would pay to borrow money.

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What Is The Yield Curve? Why Is It Important? 5

The shape of the yield curve gives us important indications of what the future holds for the economy

Now that we know what the shape of the yield curve represents and why it does so, we can finally answer the question asked in Part 1.

Why can’t it tell us the depth of a recession?

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