The Yield Curve Inverted Again

A reliable market barometer of the risk of future recessions was triggered for a second consecutive day on Friday.

The yield on two-year Treasury bonds climbed above the yield on 10-year Treasury bonds, a phenomenon known as an inverted yield curve.

The curve briefly inverted Thursday afternoon before resetting to the typical structure in which bonds maturing further in the future have higher yields than bonds maturing sooner.

As Breitbart reported:

The yield curve is regarded as a reliable predictor of recessions, having inverted before each of the last eight recessions as measured by the National Bureau of Economic Research. The yield curve inverted in 2007, foreshadowing the recession of 2008-09; and, spookily, it inverted in 2019…

The difference between the yields on the two-year and the 10-year has been narrowing for weeks. Other parts of the yield curve had already inverted, with the three-year Treasury bond yielding more than the five-year and the five-year more than the seven-year. Those yields, however, are not regarded as particularly reliable barometers.

Normally, longer maturity bonds have higher yields than shorter maturity bonds as investors demand a premium for locking up capital for longer. An inverted curve suggests that investors expect lower interest rates in the more distant future than they anticipate in the near future. Typically, investors expect lower rates because they anticipate the Fed will have to lower its target to reverse or prevent an economic downturn.

In this case, it seems that the investors suspect that the Federal Reserve’s current path of tightening monetary policy—by raising its interest rate target, increasing the interest it pays on reserves, and allowing its huge stockpile of bonds to shrink as bonds mature—will have to be reversed in the future. It may indicate that investors think the Fed will overdo the tightening, pushing the economy into a recession.

Analysts dispute exactly why an inverted yield curve predicts recessions so reliably. Clearly, the 2019 inversion was not due to investors foreseeing the pandemic and lockdown that briefly threw the economy into a recession in 2020. Some analysts think an inversion can cause a recession mechanically, perhaps by reducing the willingness of banks to lend. Others say an inversion merely reflects murkier data that indicate a recession lies ahead.

Bond yields move in the opposite direction of prices. When the yield on a bond is rising, it indicates that the price of a bond is falling.