Yield Curve Inversion: Bond Market Sends Up a Recession Warning Signal

The bond market flashed a significant warning sign about economic growth Friday morning.

The typical gap between the three-month and 10-yields reversed itself, as investor hunger for longer-term bonds pushed longer-term yields below shorter-term. This so-called ‘inverted yield curve’ is considered a reliable indicator that a recession looms sometime in the next couple of years.

The yield curve is a way to show the difference in compensation investors get depending on how long a bond takes to mature. Most of the time, the curve slopes upward because investors usually want to be paid more in exchange for locking their money up for longer.

But at times the relationship can flip, or invert, with shorter-term bonds yielding more than longer-term bonds.

That’s what happened on Friday.

Since longer-term bond yields more or less reflect the expected path of future short-term rates, this can be an indicator that investors think the Federal Reserve will have to cut its short-term interest rate target because of slumping economic growth or an approaching recession. On Wednesday, the Federal Reserve released economic projections that showed its median forecast for economic growth this year had slipped to 2.1 from 2.3 in December and that it no longer expected to raise interest rates this year.

While parts of the yield curve have inverted in the last few years, the three-month has not fallen below the ten-year yield since 2007.  Studies by Federal Reserve economists say this gap is the best predictor of recessions. The other closely watched gap, between two-year yields and the ten-year, narrowed on Friday but was still positive by around 10 basis points.

An inverted yield curve does not always foreshadow a recession, however. Intraday inversions that quickly correct to the normal relationship have often been misleading signals.

The yield curve may also have lost some of its predictive power. Very large budget deficits have increased the amount of bonds the government is selling. The government’s choices about which bonds to sell could cause an over-supply or under-supply in some parts of the yield curve, which in turn could invert the curve.

The Federal Reserve’s actions as it shrinks its balance sheet, inflated from years of bond buying under the central bank’s quantitative easing program, may also be putting pressure on the curve. This is largely an unprecedented event so its effects are hard to predict and likely will not be known for years.

The bond market is often fickle. A year ago, the market was signaling that the Fed was expected to raise interest rates three times in 2019. Now it expects no rate hikes at all.