Yield Curve Inverts: Bonds Flash Recession Warning

A key market signal of recessions was tripped on Tuesday.

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 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.  It also inverted in 2019 and the economy fell into a brief pandemic-lockdown induced recession the following year.

The yield curve briefly inverted in March and April and again in June.

The difference between the yields on the two-year and the 10-year has been narrowing for a weeks as investors have reassessed their forecasts for interest rates next year. Earlier, the fed funds futures market reflected a view that the Fed’s rate target would continue to climb through next year, eventually hitting around four percent.

Now those expectations have been upended by signs that economic growth in the U.S. may be much weaker than expected. Bank of America’s analysts think there is a 40 percent chance of recession next year. Others wonder if the U.S. may already be in a recession after the economy shrank in the first three months of the year and appears to be on the verge of a second consecutive quarter of negative growth.

Consumer spending shrank in May after adjusting for inflation, several measures of consumer sentiment have hit extremely low levels, and surveys by the Institute for Supply Management and several regional Fed banks have indicated a contraction or at least moribund growth in manufacturing. Spending on construction fell in May and spending on single-family home building was flat for the month. Factory orders, however, were stronger than expected and unemployment remains very low.

The market now appears to indicate investors think the Fed will have to stop raising rates or even cut its target next year to stave off a worse downturn. Some think the downturn will be strong enough to kill off inflation, especially if it pushes unemployment up sharply.  Others fear we could get slow or negative growth, rising unemployment, and high inflation.

Economists dispute exactly why an inverted yield curve predicts recessions so reliably. Clearly, the 2019 inversion was not due to investors foreseeing the pandemic, although it may be that the pandemic and government aid to prop up the economy essentially covered-up a recession that would have happened anyway. 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 information that indicate a recession lies ahead.

When the yield curve inverted in 2019, there were many who claimed it was “different this time.” That’s less the case today simply because many do think the risk of a recession is elevated. Some believe that the yield curve’s signal has been scrambled by the Fed’s expanded balance sheet and perhaps by the economic turbulence stirred up by the pandemic. There’s also a question of whether the yield curve’s signal might be scrambled by the fact that Treasuries of all maturities now have negative yields, meaning they would lose money if inflation remains at the current level or even at lower levels expected for the next several years.

Some economists insist that it’s not the difference between 10-year and two-year yields that matters but the difference between the 10-year and three-month yields. With the three-month yield at 1.713, that part of the curve remains un-inverted.

There have been false alarm inversions in the past. The curve inverted in 1966 and briefly in 1998 without leading to a subsequent recession. Some would count the 2019 inversion as a false alarm also—although we cannot know whether we would have got a recession if not for the pandemic.

Stocks tend to do quite well in the months following an inversion. Energy stocks, in particular, seem to do well in the aftermath of an inversion, according to research from Bank of America. In fact, energy stocks have been among the best performing stocks since the March conversion.