This economic indicator has predicted recessions in the past — but is it different this time?

It may not have escalated to the level of water cooler talk, but an obscure and obtuse-sounding economic indicator is a hot topic of conversation among the investment community of late.

The yield curve on government debt — the gap between how much long-term bonds pay out versus short-term ones — is at its lowest level in more than a decade, and opinion is somewhat divided on how bad a sign it is for the economy. 

Under normal circumstances, the yield on long-term bonds should be much higher than the yield on short-term ones to properly reward investors for the risk of waiting longer to get paid, particularly since inflation can eat away at value over time.

At various times over the past decade, the gap between long-term and short-term yields has been as high as four percentage points — or as much as 400 basis points, to use the Bay Street parlance. But lately, gaps around the world have shrunk to their narrowest point in years, leaving many experts to wonder when it may invert.

If that happens — if long-term yields dip below short-term ones — it could be a sign investors are losing confidence in the economy over the long haul. And that's a very serious situation that some economists say could throw the economy upside down.

"Markets are very firmly focused on the shape of the yield curve and its potential to invert," says Frances Donald,​ Manulife's chief economist. "Particularly the U.S. one."

Bad sign

That's because a so-called inverted yield curve has a troubling knack for showing up right before the economy is about to go pear-shaped.

The phenomenon has happened right before almost every single recession dating back to the Second World War. The most recent case where the U.S. went into recession without first seeing the yield curve invert was in 1990, but even then it came close.

Currently, the gap between the two-year U.S. bond and the 10-year bond is just 32 basis points. That's the thinnest it's been since 2007.

To Donald, how much weight you give an inverted yield curve boils down to where you stand on one question: Do they actually cause recessions, or merely show up ahead of one that was already on its way? 

Donald sums up the first perspective this way: If short-term interest rates are higher than long-term ones, it's more expensive to borrow now rather than later, which makes growth slow down and leads to recession. 

But those on the other side of the argument point out yield curves typically invert when central banks hike rates, "which raise the front end of the curve," but do nothing for the end of it, Donald says.

"Because they always raise rates at the end of [business] cycles, we tend to see inverted yield curves at the end of a cycle."

While Donald isn't among those who think an inverted curve would be a sign the sky is falling, she says it's definitely on her radar. "Getting the reason behind why it's inverting ... is one of the most important questions facing investors today."

It's also much more important when the U.S. curve inverts than when it does anywhere else.

Keep calm. Carry on

CIBC's head of rates strategy, Ian Pollick, says it's hard for him to get worked up about inverting yield curves this time around, partly because it's actually happened recently. In Canada. Last month, in fact.

Although it was only brief, the yield on Canada's 30-year bond in May briefly dipped below the yield on the 10-year bond before quickly reverting back to around a 10-point spread today.

"When we were talking to investors and talking to stakeholders," Pollick says of when that happened, "what we tried to express was that it's not saying something deleterious about the macroeconomic environment."

(That's economist-speak for: "Keep calm. Carry on.")

Pollick shares Donald's view that a narrowing yield spread is to be expected right now because central banks in Canada and the U.S. are hiking interest rates. That pushes up short-term yields, but leaves the long end of the curve as flat as ever.

So even if the U.S. yield curve inverts, "we don't think its sending a negative signal on the economy," Pollick says.

"And we don't see it as a situation that's going to persist for very long even if it does happen."