Topic: What does the yield curve tell us about recession?
The goal of any economic policy is to keep the economy heading in the right direction, expand the economy and avoid falling into a recession. There are certain policys that can be used to avoid attempt to alleviate the pain of a recession, but these need time to take hold and have an actual effect. For that reason it is incredibly important for policy makers to know as early as possible if a recession may be coming soon. To get this kind of forsight into the future of the economy many turned to the predictive powers found in the yield curve.
The yield curve is a curve showing the relationship among interest rates, at a set point in time, of bonds having equal credit quality, risk, liquidity but different maturity dates. It describes the term structure of a particular types of bonds. The most common combination for the yield curve is between three-months T-bill and ten-years T-bill. Yield curves typically have an upward slopping, in which yield is increase with maturity, it is also referred as normal yield curve.
There are three types of yield curve:
1) Normal yield curve: In a normal yield curve, long term bonds often have higher yield than short term bonds. It is because the term risk of long term bonds and the short term rates are expected to grow in the future. It is considered a sign of economic expansion
2) Inverted yield curve: The inverted yield curve has a downward slopping since the short term bonds have higher yield than long term bonds. This happen because people belief short term yields will fall in the future. It is a sign of contraction
3) Flat yield curve: When the yield curve is flat, long term rates and short term rate are the same. Yield on bonds are identical regardless of the holding period. During the flat yield curve, the economy is stable.
There are many factors that can affect the yield curve, such as GDP growth, saving and budget deficits, liquidity premium,...