Economic Impact: Time will tell how dangerous this simple curve is

The U.S. Treasury Department sells government bonds at various maturity dates — ranging from one month to 30 years — and it pays interest on that money it is borrowing. The “yield curve” simply represents the relationship between interest rates on short-term and longer-term securities.

Typically, the yield on a three-month Treasury bill is lower than on a 10-year note. That’s because there is lower uncertainty over what will happen in only three months.

For example, the holders of a 10-year note have a longer period to worry about the economy. If inflation goes from 2 to 3 percent in that decade, they will have less purchasing power when the note matures. To compensate for that risk, they demand a higher interest rate.

So the yield curve typically shows incremental increases between the three-month bill, the one-year bill … and so on, up to 30-year Treasuries.

But the curve is said to invert when the three-month yield is higher than the 10-year yield. When that happens, it indicates that investors have concern about economic growth.

For the inversion to happen, two things need to occur. One is that short-term interest rates have to rise, and the other is that long-term rates have to stay put or decline.

Here’s what has been happening lately.

The goal of the Federal Reserve Board is to bring short-term rates to a level where they don’t cause the economy to accelerate so much that inflation rises.

For two years, the Fed has been raising the federal funds rate target — the overnight rate that banks use to lend money to each other. The yield on the three-month bill rises almost in lockstep.

The Fed has raised the fed funds rate target to a range of 2.25 to 2.5 percent. That pushed the three-month yield to 2.46 percent for the week ending March 22, while the 10-year yield closed the week at 2.44 percent. (The March 29 closing yields were not quite inverted, with the three-month figure at 2.40 percent and the 10-year at 2.41 percent.)

Typically, when short-term rates rise, so do long-term rates. But this has not happened lately — because investors are concerned that economic growth will slow. That would mean lower yields in the future.

So what do investors do? They buy more long-term Treasuries now to lock in current higher yields. The increased demand for long-term notes causes the price to go up, and the yield comes down — because Treasury prices and yields move in opposite directions. When this process pushes long-term interest rates below short-term rates, it results in yield curve inversion.

Since 1956, an inverted yield curve has preceded every recession by a year and a half or so. We’ll know before long whether today’s bond investors are right this time.