The "yield curve" refers to a graph showing the relationship between the maturity length of bonds—such as one month, three months, one year, five years, twenty years, etc.—plotted on the x axis, and the yield (or interest rate) plotted on the y axis.1 In the postwar era, a "normal" yield curve has been upward sloping, meaning that investors typically receive a higher rate of return if they are willing to put their funds into longer-dated bonds. A so-called inverted yield curve occurs when this typical relationship flips, and short-dated bonds have a higher rate of return than long-dated ones.
Investors and financial analysts are very interested in this phenomenon, because an inverted yield curve (defined in a particular way) has been a perfect leading indicator of a recession going back at least fifty years. If we look at the last eight recessions, beginning with the downturn that began in December 1969, an appropriately defined yield curve inversion preceded all of them about a year ahead of time. Moreover, during this same fifty-one-year period the (appropriately defined) yield curve has only inverted when there would soon be a recession. (See the endnotes for citations to the scholarly literature.2) The following chart illustrates the yield curve's apparent predictive power:
In the above chart (which only goes back to the early 1980s and so doesn't cover the full extent of the yield curve's successful track record), we have charted the difference (or "spread") between the implicit interest rate on ten-year Treasury bonds and three-month Treasury bills. The normal state of affairs is for the yield on the longer ten-year security to be higher than the yield on the very short three-month security. (That's why the line in the chart is typically above the black horizontal line at the 0 percent notch.)
However, every once in a while the yield curve inverts, meaning that the line in the chart dips below the 0 percent threshold, corresponding to a situation in which the yield on three-month T-bills is actually higher than the yield on ten-year Treasury bonds. Notice in our chart that whenever that happens—and only when that happens—the economy soon goes into a recession (indicated by the gray bars).