…

Since 1970, every time short rates have been higher than long rates – a condition called an inversion – the Standard & Poor’s 500 composite and the S&P/TSX composite index (formerly the TSE 300) have had negative or flat earnings growth. The curve showed relatively high short rates before the dot-com bust in 2000. Investors who heeded these warnings could have sold off their stocks ahead of the collapse.

The yield curve predicted the present economic malaise. In the 15 months leading up to the subprime housing that began last August, the U.S. Treasury curve was showing relatively high short-term rates. Says Anthony Crecenzi, author of the 2002 bestseller (in fixed income analysis circles, that is), The Strategic Bond Investor, “few indicators with such a stellar forecasting record have the yield curve’s simplicity.”

Its ability to predict economic growth or contraction 12 to 18 months ahead far exceeds the power of other analytical tools, including the analysis of far more esoteric macroeconomic indicators that track things like orders for tools that make other tools. As well, the yield curve beats folk tales about hemlines and Super Bowl winners.

To make use of the yield curve, one needs to understand its nuances, which appear in the shapes it can take.

Normal slope: Investors expect the economy to grow and, with that growth, to generate inflation. Investors expect a higher yield in the future when inflation is higher and erodes their returns on the bond. In each successive period, the central bank will have to raise interest rates a little. A progression of higher interest rates and the risks of parking money for many years as well as giving up liquidity all justify rates rising over time.

Steep slope: Characteristic of the beginning of an expansion or the period when an economy comes out of recession. The curve will be at, say, three percentage points higher at 30 years than at 90 days. The steeper any yield curve, the greater is the incentive to park money in long-term bonds and the lower is the relative cost of borrowing short.

Flat curve: Shows all terms have similar yields. It is a mixed signal in which investors cannot agree on what lies ahead for the economy. In application, it means that there is very little for the investor to gain by buying a 30-year bond rather than a 30-day bond. At most, the flat curve offers yield protection, Mr. Jong notes. There is no premium for taking on more time risk, but the investor can at least lock in a return for as much as 30 years.

Higher rates for short than long bonds, often called an inverted curve: Predicts recession or shows a market crisis. The future in which interest rates, that is, the return on money, is lower than in the present is a clear signal of bad times to come.