- A yield curve inversion has predated the last nine recessions.
- But does the most recent inversion portend a recession? For now, no.
- The duration of the inversion matters, not just the inversion itself.
The most followed yield curve term spread is the difference between the US 10-year yield and the US 2-year yield. The yield curve is said to be inverted when the 2-year rate yields more than the longer 10-year rate.
Research shows that an inverted yield curve has predated the last nine recessions, with one false positive.1 It’s usually talked about as a reliable indicator that a recession may be on the horizon.
While the fact that an inversion has preceded every recession over the past 70 years is noteworthy, there is more to the story. And the current market has a “this time is different” feel.
The slope of the yield curve reflects information about current and expected future monetary policy actions (the short end) as well as the market’s attitude towards risks, growth, and inflation (the long end). Both are linked to the expectations of future business cycle outcomes.
Right now, as the Federal Reserve (Fed) seeks to reign in elevated inflation levels, it is expected to continue to hike rates for the rest of the year. The market is expecting at least eight more increases in 2022.2 This would put the Federal Funds Rate at an implied level of 2.4%.3
This has pushed short-term rates up 160 percentage points over the last three months to 2.34%.4 Long-term rates, however, have also risen (a bear flattener) by 88 percentage points to 2.39%,5 as growth and inflation continue to remain above trend and investors are seeking a premium for lending their money that far out in the future.
Yet, these two moves have compressed the spread. In a recent client meeting I was asked, “What is the yield curve telling you?” I responded that both rates are nearly the same — and I was serious. Right now, the yield curve is not telling me much about a looming recession, the question the client was really asking.
There are two factors at play:
- The historical precedent has a large error term.
- Real rates are currently negative and quantitative easing (QE) has suppressed the long end.
The Yield Curve’s Historical Precedent
Much has been written about the relationship between interest rates and the economy. Rudebusch and Williams (2009) showed that an inverted yield curve reliably predicts low future output growth and indicates a high probability of recession. Estrella and Mishkin (1997) found that this relationship holds both in the United States and for multiple other advanced economies.
As a result, the term spread metric is closely watched by professional forecasters and policymakers. The numbers also back it up. The chart below shows that, using a spliced version of the US 1-year and US 2-year yield (given the latter didn’t start trading until the 1970’s) from January 1955 to now, an inverted yield curve has predated all nine recessions.
With just one false positive in 1965, that’s a 90% hit rate overall. In 1965, the economy did enter a slowdown — not a recession — consistent with a portion of the economic theory above about the yield curve portending slower growth.
Monthly View of Yield Curve and Recessions
But the delay between the term spread turning negative and the beginning of a recession has ranged anywhere from six to 24 months. That’s quite a gap! That means the yield curve could invert and, at a minimum, an entire baseball season could be played before a recession even began. At the long end, it could be two years before a recession hits. So while the yield curve inversion’s hit rate is high, its timing leaves a lot to be desired.
With so many other variables impacting the pace of the economy over a six- or 24-month duration, it’s hard to conclude that an inverted yield curve indicates a recession is imminent. While the yield curve inverted in 2019 and a recession followed in 2020, the reason for the recession was a global pandemic. That’s not something the yield curve could have forecasted.
1 Economic Forecasts with the Yield Curve, FRBSF Economic Letter, March 5, 2018.
2 Bloomberg Finance L.P., as of March 30, 2022, based on implied futures pricing.
3 Bloomberg Finance L.P., as of March 30, 2022, based on implied futures pricing.
4 Bloomberg Finance L.P., as of March 30, 2022.
5 Bloomberg Finance L.P., as of March 30, 2022.
6 Bloomberg Finance L.P., as of March 30, 2022, based on consensus forecasts.
7 Bloomberg Finance L.P., as of March 30, 2022, based on calculations by SPDR Americas Research.
8 Bloomberg Finance L.P., as of March 30, 2022, based on the holdings reported by the Federal Reserve.
Bear flattener refers to the convergence of interest rates along the yield curve as short-term rates rise faster than long-term rates.
Originally Posted April 1, 2022 – What Is the Yield Curve Saying Now?
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