The bond yield curve is an economic predictive tool that only began to be generally appreciated in the 1990’s, and there’s a great Java Applet that allows you to look at the yield curve for any time during the last several years here.
A short course on using the applet: The right-hand graph shows the S&P 500, and there is a movable vertical line (red), that you can drag left or right to pick a moment in time.
The left graph displays the Yield Curve for the point in time selected by the slider on the right graph. Its Y axis shows interest rates, and its X axis has the term length of the Treasury bill: short-term bills on the left, stretching out to 30-year bills on the right). You can also adjust the “Trail Length” slider on the left graph, which controls “the length of the comet’s tail” — how many days’ worth of preceding yield curves show up as shadows. If you drag that “Trail length” slider all the way left, you get just a sharp line, and as you drag it more to the right, you see a more fuzzy area showing you where it had been in the few days before the time shown.
Now, when we speak of a “flat yield curve”, or an “inverted yield curve”, we usually are comparing, say, the 3-month Treasuries with 10-year Treasuries, or perhaps 2-year vs. 10-year.
So, drag the slider on the right-hand (S&P 500) graph to 3 August 2000 or so (the date is displayed on the left graph, while you’re selected it on the right graph), near the S&P peak. Now look at the yield curve on the left graph. Compare the short-term yields to the 10-year yields. It’s become flat, actually a little downward-pointing. That’s bad: 5 out of the last 6 times, that’s meant recession, starting 2 to 6 months out. Officially, the recession started in March 2001 (6 months later), but I know that data switch sales fell off a cliff in December 2000 (3 months later), so that was a pretty good indicator.
As you drag the date/time slider on the right graph towards the right, the yield curve (looking only at the short-term to 10y segment) doesn’t start looking more normal until about a year later, around August 2001, and by 18 January 2002 is looking very positive. The recession didn’t officially end until November 2002, though, so that’s much more of a lag.
Now, let’s look at the spread between the shortest-term bills and the longer term bills on several different dates:
Short vs. 10Y 08/03/2000 -0.25% First Inversion 12/08/2000 -0.50% Data Switch Sales Plummet 01/02/2001 -0.75% Recession Still Quite Not Official 03/19/2001 +0.25% Recession Official (But Note That S&P 500 Had Already Fallen About 300 Points Aug-Mar) 04/05/2002 +3.50% After several aggressive Fed Moves Much of 2002-2003 +2.00% S%P sputtering up and down here. Last part of 2003 +3.00% Gaining Steam 05/11/2004 +4.00% Wow! Pre-election Impetus? 02/18/2005 +1.25% Much Flatter, But Still Positive 12/07/2006 Oh, it's flat.
Oog, flat yield curve, housing bubble popping – be wary, and if it inverts for a sustained period, look out below!
(Edited to reflect Chris Gibson’s corrections)