1. The yield curveThis is far less complicated than it sounds. The yield curve is the difference between the interest rate (yield) on a longer-dated bond (debt issued by a corporation or country) and a shorter-dated bond. For instance, typically it should cost less to borrow money for two years than for 10 years. This is because the economy is expected to grow over time and experience inflation. Inflation erodes the fixed return of a bond and investors tend to want compensation for taking on that risk. They therefore demand a higher yield for longer-dated bonds, so the yield curve should slope upwards. However, when it costs more to borrow money in the short term than it does in the long term, the yield curve inverts. The yield curve has been a reliable predictor of US recessions over the last four decades. Its track record in the UK is less dependable. Nevertheless, a UK yield curve that is close to inverting suggests at best that investors expect the economy to slow, at worst it might be an early signal a recession could be on the way. In the example below, we look at the difference between the yields on a two- and 10-year gilt, which is a UK government bond.
Currently a two-year UK government bond yields around 0.8 per cent. This compares with a 10-year which yields around 1.2 per cent. The interest rate on the longer-dated bond is more than the shorter dates but this gap has been narrowing. Before the Brexit vote the comparable yields were 0.6 per cent and 1.9 per cent respectively. The sharp fall on the graph below, in 2016, coincided with the Brexit vote. That was a signal, rightly or wrongly, that investors were concerned about the outlook for the UK economy. Should the line on the chart dip below zero, this would indicate that the yield curve had inverted. This is as close to happening now as it ever has been since the vote.