What is the yield curve, and why is it making investors nervous?

The "yield curve" has been creeping up the headlines in the last week or so. What is it, and why is it worrying some people?

Yield curve sounds a bit technical. But the concept is pretty simple. Let's start with the very basics.

A bond is an IOU. Some of these IOUs pay out ("mature") next week, and some of them don't pay out for 30 years or more. In the meantime, they pay interest to the holder of the IOU.

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The annual interest paid out, expressed as a percentage of the price of the bond, is the "yield". In effect, this is the interest rate on the bond.

A yield curve takes a look at bonds from the same issuer, and compares the yields across different maturities, starting with the shortest-term bonds.

The most important yield curve in the world is the yield curve for US Treasury bonds. US government debt is generally deemed the safest in the world. The US won't default on its debt (probably) although it might repay you in dollars that aren't worth as much as you had hoped they would be.

So US debt is effectively used as a reference price for most other assets. If you can get a 2% annual interest rate on US debt, for example, then you'll need a better prospective return than that to convince you to buy something much more risky.

The yield curve on US debt gives us an idea of what investors expect for the future. Usually, the yield curve goes up from left to right. In other words,long-term interest rates are higher than short-term ones.

That's logical. If you ask me for a loan for ten years, then I'll expect a higher interest rate than if you say you'll give me the money back in six months' time. Even if I entirely trust you to repay me, I still have to account for the fact that inflation might soar over that time I need you to pay me to take that risk.

What's grabbing everyone's attention right now is that the US Treasury yield curve is flattening.

What this means is that the gap between long-term interest rates and short-term ones is getting narrower. In other words, investors will accept almost the same level of interest rate for lending out their money over two years as they will for ten.

Indeed, the gap between the two is now at its lowest level since 2007. Which was, of course, directly prior to the biggest financial crisis in recent history.

What if the yield curve goes pear-shaped?

Now, why might that be?

Well, if investors are sceptical about rates rising in the medium term, then it suggests that they don't see inflation taking off. In turn, that suggests that they're sceptical about growth. In other words, they see no reason for interest rates to rise.

You might think that this sounds fine. After all, who wants higher rates when we all own so much debt?

Unfortunately, it's not that simple. If the economy isn't growing fast enough to spark inflation or interest rate rises, that generally means one thing that the economy is in fact, in recession.

In other words, a flattening yield curve indicates that investors expect tougher economic times ahead. And once the yield curve "inverts" ie long-term rates fall below short-term ones that is a reasonably reliable recession indicator (it's happened before every recession over the last 30 years or so).

Is there a benign explanation for all this? Bill Gross, formerly the "bond king", reckons that the yield curve, down at these levels, is indicating that markets are more sensitive to rising interest rates. He thinks the current curve is sustainable but that investors need to watch out if the Fed raises rates to above 2%.

He also reckons that money flooding in from around the world is keeping long-term US yields down (the higher that bond prices go, the lower yields go, and vice versa). The yield on longer-term US debt is still a lot higher than that on German bunds or Japanese bonds.

All else being equal, that should make it attractive to overseas investors. There's a logic to that, although the issue of currency risk makes it much trickier many have pointed out that once you account for the cost of "hedging" (ie making sure that if the dollar falls, you don't lose out as an overseas investor), then Treasury yields are no longer as appealing as they might seem on the surface.

Anyway, that's one explanation. Another is that investors are simply very sceptical about economic prospects, and are starting to price in a slowdown, and perhaps a recession.

I'm not so sure. I suspect that investors might simply have grown too used to the idea that long-term interest rates will remain low. This might represent end-of-bubble complacency rather than any accurate forecast for the future. But we'll keep an eye out to see what happens next.

I look at the yield curve in more detail in the forthcoming issue of MoneyWeek magazine (get your first four issues free here).