Yield Curve: What Is It Really Predicting?

The yield curve is now as widely followed by the financial press as movie stars are followed by paparazzi. The tabloids often comment on any noticeable changes in the physical features of the celebrities they stalk. Similarly, the financial paparazzi are obsessed with the shape of the yield curve.

The spread between the "long end" and the "short end" of the curve is widely deemed to be a great leading indicator of recessions when it goes negative. Such yield "inversions" do have a good track record of occurring several months before the start of recessions.

In this Topical Study, Edward Yardeni and Melissa Tagg explain that the yield curve neither predicts nor causes recessions. Instead, it predicts the monetary policy course likely to be pursued by the Federal Reserve. Among the topics covered are:

1. The relationship of the business cycle to the monetary and credit cycles.

2. How the shape of the yield curve anticipates financial crises, and reacts to them.

3. The impacts of globalization on the US bond market and the shape of the yield curve.

4. How to use the yield curve to predict the Fed's moves and to anticipate recessions, which are always bearish for stocks.

This study includes a "Primer on the Yield Curve," based on "Dr. Ed's" book, Predicting the Markets (2018). It also includes several charts useful for gleaning more insights into the relationships of the yield curve to the economy and to financial markets.