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? 6

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

Which takes us to the second form of real money, bank loans.

We already know that an inverted yield curve signals that liquidity conditions are tight in the near term relative to the long, meaning that demand for short term borrowing is high.


In other words, a shortage of money.

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What Is The Yield Curve? Why Is It Important? 7

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

The way to see that central bank policy is doomed to be ineffective is to understand how modern monetary policy really functions.

Today’s central banks rely almost exclusively on bank reserves as a policy lever. This means that their moves to increase or decrease interest rates, or to pump “money” into the economy, are all based on bank reserves.

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What Is The Yield Curve? Why Is It Important? 8

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

The second reason the yield curve can’t really tell us the depth of a future recession is because of external shocks.

For some reason, or just out of randomness, large negative shocks tend to materialize when global economic conditions take a turn for the worse.

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What Is The Yield Curve? Why Is It Important? 9

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

Let’s conclude our discussion on the yield curve with the role of central banks, namely the Fed.

Where is the Fed, and it’s supposed control over interest rates in the previous parts of our discussion?

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What Is The Yield Curve? Why Is It Important? 10

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

It is widely believed that the Fed only controls “short term” rates. “Short term” in conventional market wisdom means up to the 2 year mark on the yield curve, that is, US 2y yields.

Hence, yields up to the 2y mark are “supposed” to move the most when the Fed changes the Fed Funds Rate.

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