(LifeWire) - The yield curve, one of the key statistics that economists and investors use to try to divine the future course of the economy, is simply a measure of the difference between the interest rates on short-term loans (or bonds) and those on long-term loans (or bonds).
Under normal economic conditions, interest rates on short-term loans are lower than on long-term loans. This is because there's less risk that a company such as, say, General Motors will default on its debts in the next 30 days than there is that it will go belly-up in the next 30 years. There is also less risk that inflation will eat into the value of money repaid on a loan in three months than on a loan that is repaid three decades from now.
Less risk for the lender equals a lower cost for the borrower - in other words, short-term money comes with lower interest rates.
Sometimes, though, that comfortable world of risk and reward turns topsy-turvy and short-term rates actually creep higher than rates on long-term loans. What results is known as an inverted yield curve, and although it doesn't quite describe a world where whales swim in the air and elephants walk the sea floor, it comes somewhat close in economic terms.
Inverted yield curves have been among the most reliable predictors of recessions in the modern economic era. Economist Arturo Estrella, writing for the Federal Reserve Bank of New York in 1996, credited the curve with effectively predicting every recession since 1950, with the exception of "one false signal" in 1967. Even that signal, which failed to predict an actual recession - defined by a sustained shrinkage in gross domestic product - still preceded a significant credit crunch and a slowdown in economic production.
Drawing the Curve
The yield curve is generally drawn by plotting interest rates on US Treasury issues, such as the three-month Treasury bill and the 10-year US Treasury note, on a graph. Under normal conditions, the curve will slope upward, as rates increase with the time period on loans. An inverted yield curve will slope downward, as longer-term debt comes with lower yield.
Why should it matter to anyone on Main Street what lenders are charging people for different types of loans on Wall Street? As with most phenomena in economics, people disagree on this point. They disagree, for that matter, as to whether the yield curve is an actual predictor of future activity or simply a historical coincidence, although an inverted curve has been a leading indicator of downturns in other national economies, such as South Korea's and Great Britain's.
The reasons why the yield curve matters, however, have little to do with the actual price of money and everything to do with the economic expectations of lenders and borrowers.
Inflation Is Key
One of the key considerations in the minds of investors who buy long-term loans in the form of bonds or Treasury notes that will pay interest over a long stretch of years is inflation. The higher inflation runs, the less money will be worth in the future. This means that higher interest rates must be charged on long-term loans to make up for the deficit. If the expectation for future inflation remains low, interest rates can run lower and still attract investment money.
So what happens when a shock hits the economy, such as a sharp interest rate increase from the central bank that threatens to lessen production and economic activity in the short run? The general expectation might be for uncertainty in the short term, both for specific businesses and for the overall economy, resulting in a higher risk assessment - and thus a higher interest rate - on short-term money.
However, economic slowdowns generally have a dampening effect on inflation. This tends to reduce the risk, and therefore interest rates, on long-term debt. The net effect is a flattening, or actual inversion, of the yield curve, with short-term loans growing more expensive and long-term loans growing cheaper, driven largely by investor expectations of a rocky road in the near future.
Aside from measuring the general economic mood, of course, a flat or inverted yield curve does have an immediate effect on certain businesses. Banks, for instance, tend to find profits squeezed because they have to pay more to attract short-term money in the form of CDs and other investor deposits in order to make long-term loans. This phenomenon is known as yield compression, and it indicates that bank stocks may undergo some downward pressure.