A quick note on the yield curve for Alex Balk

By Felix Salmon
May 13, 2009

Let’s say you have two apples. You’re scared of losing those apples, and you want to be sure that they’re absolutely safe. So you give them to the government, and in return the government promises to give you back two apples in a year’s time. You’re happy, and the government gets to eat your apples today, not worrying about paying you back until this time next year. So the government’s happy too. This is known as a “flat yield curve”, and it tends to happen when the economy is depressed and the general mood is rather grim.

Let’s say you have two apples. They’re delicious, and abundant, and you reckon that if you eat them now you’ll be full of vim and vigor and will have the wherewithal to find lots more apples if and when you need them in the future. So before you give the government your two apples today, the government needs to promise to give you back three apples in a year’s time. This is known as a “steep yield curve”, and it tends to happen when people are more optimistic about the future.

Caroline Baum says — rightly — that looking at the yield curve is a much better way of predicting the future than listening to economists. (Which isn’t saying much.) Right now, the yield curve is steepening quite dramatically, which Baum reckons constitutes a sign that “a proliferation of green shoots calmed investor fears of an endless dark winter”.

And what is Baum talking about when she says that between 2006 and 2008 the yield curve was inverted? Well, in cases like that, the yield curve is like a bowl of fruit. It’s great right now, and it’s a lovely day outside, and you’re rather hungry, and you have a bottle of Champagne open, and so if the government wants to take your fruit off you now and give you back a fresh bowl in a week’s time, that fresh bowl is going to have to be substantially bigger than the one you’ve got today.

On the other hand, if the government wants to swap your bowl of fruit today for an identically-sized and just as tasty bowl of fruit all the way out on Christmas Day, then you’d be more interested. You know it’s going to be cold at Christmas, and you know that you’re really going to value that fruit a lot, because fruit won’t be as abundant then as it is now.

So while the yield curve is steep between now and one week, it’s flat between now and Christmas. That’s known as an “inverted yield curve”, and it’s often a sign that things are going to get worse.

On which note I’m going to sign off for the rest of the week. There might be the occasional posting, but nothing regular: I plan to be stomping around fields in Vermont and admiring lines on walls in North Adams. No major bank failures while I’m gone, you hear?

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