The yield curve inverted again; is recession next?

Recently, an interesting tidbit of financial news squeezed into the headlines, which had been dominated thus far by the Ukraine war and the Oscars slap. The news was that the so-called “yield curve” had inverted, flashing warning signs of an imminent economic recession. The yield curve had been flattening for about a year and first inverted briefly on Thursday, March 31, 2022, during intra-day trading, before reverting back to normal. By April 1st, however, no doubts remained, as the yield curve stayed negative.

Yield curve inversion tends to be a big deal in finance, because they have an uncanny ability to predict economic recessions, although some argue that this economic indicator is overblown. Let’s take a look at why yield curve inversion is so newsworthy.

What is the yield curve?

A yield curve is simply the relationship between the interest rate versus the duration (to maturity) of a debt instrument, such as a loan or a bond. Typically, debts of shorter duration carry a lower interest rate, and debts of longer duration carry a higher interest. This results in the depiction of a generic yield curve here, which has an upward slope:

A “normal” yield curve. Source: Visualcapitalist

For example, if all else is equal, a 10 year fixed mortgage will tend to have a lower interest rate than a 30 year fixed mortgage. Similarly, a bank offers less interest on a 12 month CD versus a 60 month CD. The theories behind this relationship are surprisingly complex, although one explanation is that investors prefer having liquidity versus tying up their money for a long time period; therefore, investors in shorter-term instruments must pay a “liquidity premium”, or, in the case of shorter maturity bonds, must accept a lower interest rate.

The yield curves that get people excited, however, are exclusively referring to U.S. government bonds, also known as treasuries or treasury bonds. These bonds are unique in the investing world. While no debt is entirely risk-free, treasury bonds are considered risk-free investments because they are backed by the “full faith and credit” of the U.S. government. In fact, 10-year treasury bonds are often used as the benchmark for the so-called risk-free rate, which is the maximum return you can receive on a theoretical investment that had zero risk.

The table below shows the yield rates for U.S. treasuries of various maturities for a particular date (4/11/2022). This information changes daily based on supply and demand for these bonds, and can be found on the U.S. Department of the Treasury website:

Daily U.S. Treasury Yield Rates
Date	1 Mo	2 Mo	3 Mo	6 Mo	1 Yr	2 Yr	3 Yr	5 Yr	7 Yr	10 Yr	20 Yr	30 Yr
04/11/2022	0.22	0.54	0.77	1.23	1.85	2.50	2.73	2.79	2.84	2.79	3.02	2.84

When we plot this information in a graph, we see the expected relationship between time to maturity and the yield:

Pay close attention to the yield of the 2-year treasury compared to the 10-year treasury. On 4/11/22, we can see that the 10-year treasury yield was 2.79%, and the 2-year treasury yield was 2.50%.

What is yield curve inversion?

The difference in yield between a treasury of longer maturity and one of shorter maturity is the spread between the yields. In finance, there is a particular spread which is closely watched by economists: the spread between the 10-year and 2-year treasuries, often known as the 2-10 spread. Under normal circumstances, the 10-year treasury has higher yield than the 2-year. Every once in awhile, however, the reverse occurs, where 2-year treasury bonds have higher yield than their 10-year cousins. This phenomenon is known as a yield curve inversion.

For example, on 4/11/2022 (in the table above), this spread was 0.29%, or 29 basis points, meaning that the 10-year treasury had higher yield than the 2-year treasury, but just barely. But a few days earlier on 4/1/22, this spread had become negative. This graph, courtesy of the Federal Reserve Bank of St. Louis, shows the daily spread between the 10-year and 2-year treasuries at the end of March 2022:

The 2-10 yield curve inverted briefly in April 2022 (where the spread dips below 0)

Why is it a big deal?

The U.S. treasury yield curve is one of the most closely-watched economic and stock market signals. Over the past year or so, the yield curve has been steadily “flattening” (i.e., the spread between 10-year and 2-year treasuries has been shrinking), until the curve inverted in April 2022:

The recent yield curve inversion was preceded by one year of yield curve “flattening”

The reason that this spread is so closely scrutinized is simple: the 10 & 2-year treasury spread is one of the most reliable predictors of economic recession. Yield curve inversion does not happen very often, but when it does, it usually heralds an economic recession within the next year or two. Prior to April 2022, the last time the 2-10 yield curve inverted was in August 2019. Many observers predicted that a recession was imminent, and in fact, this yield curve inversion was followed by the COVID-19 recession and stock market crash less than one year later:

2-10 yield curve inversion in August 2019 “forecasted” the COVID-19 recession (shaded area indicates economic recession)

So how reliable is this indicator? As it turns out, in the United States, yield curve inversions has preceded every single economic recession since 1955 by 6 to 24 months.

2-10 yield curve inversions in history, followed by economic recession 6-24 months later. This graph only goes back to 1977.

In the chart above, we can clearly see that every single recession (shaded area) is preceded by a brief period of yield curve inversion, usually occurring a few months prior. Note that during normal economic expansion cycles, the 10-year treasury yield is often several percentage points higher than the 2-year yield. Yield curve inversion is not normal!

The following table lists 2-10 yield curve inversions since 1955, and whether they were followed by an economic recession (as recognized by the National Bureau of Economic Research, or NBER) within 24 months. Note that the names for economic recessions are often different than their accompanying stock market crashes. For example, the early 2000’s recession is often better known as the dot-com bubble. (Wikipedia has a list of these recessions, and individual articles on each one).

Yield Curve Inversion	Recession within 24 months?
February 1956	Recession of 1958
October 1959	Recession of 1960-61
December 1965	No - false positive
December 1968	Recession of 1969-70
March 1973	1973 - 1975 recession
September 1978	1980 recession
September 1980	1981 - 1982 recession
January 1989	Early 1990s recession
June 1998	No - false positive*
February 2000	Early 2000s recession
December 2005	Great Recession
August 2019	COVID-19 recession
April 2022	???
*Some consider this to forecast the 2000's recession, but it does not meet the 24 month criteria.

So, to summarize, yield curve inversion has preceded every economic recession since 1955 by no more than 24 months, with the exception of 2 false positives in 1965 and 1998. There have been 12 yield curve inversions (not counting repeated inversions following the initial one) and 10 recessions since 1955, so yield curve inversion seems to be a strong predictor of imminent recession. There have been no recessions without a preceding yield curve inversion since 1955.

Does this mean another recession is coming?

The short answer is yes, but not because of the yield curve. It’s not a question of if, but of when.

The nature of economic cycles means that there will always be periods of expansion and contraction. Another recession will come sooner or later; the only unknown is timing. For the doomsayers, inverted yield curve means that the next recession is going to occur between now and 2024. Many people believe that we’re at or near the end of an economic expansion cycle, associated with high growth, historically low unemployment and interest rates, and increasing inflationary pressures. Inevitably, a period of cooling off will follow, but if mismanaged, these often turn into recessions instead.

But what do yield curves have to do with this? Why do yield curves invert in the first place? Bond markets are quite complex and the reasons that yield curves invert are beyond my understanding. In simple terms, however, 10-year treasury yields will drop if there is a surge in demand for them, relative to 2-year treasuries. So why are 10-year treasuries in high demand?

Here’s my overly simplistic stab at an explanation: we do know that the Federal Reserve plans to aggressively hike interest rates (which are at historical lows) to combat rising inflation. This makes it more expensive to borrow money, and is widely expected to slow the economy. However, many are doubtful that the Federal Reserve can engineer a so-called soft-landing, where it can rein in inflation without slowing the economy too much. Raising interest rates too aggressively can result in a recession instead. Recessions are usually accompanied by stock market downturns, which can take years, or sometimes up to a decade to recover from. If you believe a recession is imminent (in the next year or two), a 10-year treasury might represent the perfect asset and duration to put your money in instead. Finally, locking in a 10-year treasury yield now might be preferable if you expect that the Federal Reserve will be forced to aggressively cut interest rates again when the next recession hits.

Therefore, a surge in demand in longer-term treasuries signals a flight to safety, as market participants are increasingly worried about the economy in the short-term. This surge in demand causes the 10-year yield to drop (as people are willing to pay higher prices for the same bond, so the effective yield decreases), to the point where they are willing to hold a 10-year treasury even if it has less yield than a 2-year treasury.

The Federal Reserve is well-aware of the public’s obsession over the 2-10 spread. Not all economists believe that the 2-10 yield curve inversion portends anything, however. In a recent FEDS notes, Fed researchers noted “…the perceived omniscience of the 2-10 spread that pervades market commentary is probably spurious” and that “It is not valid to interpret inverted term spreads as independent measures of impending recession. They largely reflect the expectations of market participants. Among various terms spreads to consider, the 2-10 spread offers a particularly muddled view.” In fact, they call the relationship between 2-10 yield curve inversion and recession a “reverse causality”.

I should note that proponents of the ability of the yield curve to predict recessions generally only focus on data after 1955, so there’s some cherry-picking involved. From the Great Depression to 1955, the U.S. experienced four recessions (Recession of 1937 - 1938, Recession of 1945, Recession of 1949, and Recession of 1953), none of which were preceded by yield curve inversion. Since 1955, yield curve inversion has preceded all 10 recessions in the U.S., albeit with two false positives, as per the table above. Therefore, yield curve inversion does not guarantee that recession will follow within 24 months, nor does every recession need yield curve inversion as a herald.

Help, I don’t know what to do!

As usual, the future is as clear as mud, and trying to predict the future using the past can fall victim to several logical fallacies. In some ways, I could argue that believing in the yield curve inversion theory is akin to believing that bond traders, as a collective, can predict the future. A recession may or may not be coming in the next year or two. Even if it does, we have no idea how severe it will be or how long it might last. I should point out that the previous recession (COVID-19 in 2020) was accompanied by a precipitous drop in both the stock market and in economic activity, followed by the quickest economic and market recovery in history, such that the S&P 500 actually ended year 2020 up 16.26%. This means that even if we have a recession, attempting to time the market is all but impossible.

No one can predict the future, so perhaps all of the hoopla around yield curve inversion is just hand-wringing without being particularly helpful or instructive. We already know that recessions and market downturns are part and parcel of investing. Yet market downturns also represent excellent opportunities to buy assets at a discount. My main take-away is that if you’re a passive investor like me, with a reasonably long time horizon, you should probably just keep doing what you’re already doing, without trying to time the market. It’s also always a good idea to make sure that your asset allocation and how much risk you’re taking is appropriate for your age.

Whether we have another recession or not, the basic fundamentals of personal finance (i.e.: have an appropriate emergency fund, have a budget, be frugal, don’t live beyond your means, pay off debt, and invest steadily over time) will likely serve you well. This is even more critical if you have a job that is particularly vulnerable to recessions (leisure, hospitality, retail, many service industries, to name a few). Beyond that, don’t worry about things that are out of your control. I hope you enjoyed this article on yield curve inversions. As always, thanks for reading and happy investing!