So, like, what is the yield curve?

Concerned business people looking at financial report on computer screen at office
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Lots of smart people are keeping an eye on the yield curve.

Simply put, the yield curve is the difference in interest rates between long- and short-term government bonds. Think 10-year Treasury notes versus two-year notes.

When things are going well for the economy, rates on long-term bonds are higher than rates on short-term bonds. In exchange for the risk that goes with locking away your money for a longer period, you get higher interest.

It's protection against the inflation that can flare up during a stronger economy and hurt the value of your money.

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What's the problem now?

But recently, long-term bond yields have been tumbling.

Nervousness over the U.S. trade war with China has prompted investors to buy up government bonds as a safe haven for their money. The demand for bonds has pushed their prices higher, and when that happens their yields — or interest rates — go lower.

What's causing experts to worry is that shorter-term investments are starting to pay higher interest than longer-term ones. That's called an inverted yield curve — and historically, it has spelled recession.

"When the yield curve inverts, it’s not the time to borrow money to take a vacation to Orlando," says Duke University finance professor Cam Harvey, in an interview with Research Affiliates. "This is the time to save."

If you don't have an emergency fund, you'd better get going on that quickly.

Why should we trust it?

Storm Clouds Saskatchewan wind farm Swift Current Canada
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An inverted yield curve indicates an economic storm is coming.

The interest rate flip-flop has some financial pros ready to turn on Wall Street's version of a tornado siren.

Here's why: The yield curve has accurately predicted every recession over the past 60 years. The sole exception was in the mid-1960s. But even then, the economy slowed down drastically, stopping just short of a recession.

Note that while an inverted yield curve can indicate a recession is coming, it's no help with telling us when that will happen.

Sometimes, a recession has come six months later. Other times, it has taken as long as two years.

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What should you do?

The last thing you want to do is panic. Because if everyone starts worrying about a recession, that can be enough to send the economy right into the tank.

But it doesn't have to be a self-fulfilling prophecy, says Professor Harvey.

"The inverted yield curve is a tool that allows consumers and investors to take measures which could indeed slow the economy as well as protect themselves," he says. "It could also maximize the chance we will experience a soft-landing recession."

And we can handle that, Harvey says.

So, don't do anything rash that could ultimately be stacking your own deck against you. Instead, keep spending as usual — and do your part to help keep the economy healthy.

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About the Author

Doug Whiteman

Doug Whiteman

Former Editor-in-Chief

Doug Whiteman was formerly the editor-in-chief of MoneyWise. He has been quoted by The Wall Street Journal, USA Today and CNBC.com and has been interviewed on Fox Business, CBS Radio and the syndicated TV show "First Business."

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