Banking & Finance and Government

Does the inverted yield curve signal an economic recession?

April 30, 2019
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You might have heard that on March 22, the yield on the U.S. 10-year Treasury note dipped below the yield on the three-month Treasury bill. This trend is called an inverted yield curve, the first since mid 2007, and it has left many investors wondering if it signals that the U.S. economy is slowing down and a recession is imminent.

What exactly is an inverted yield curve and why does it matter?

A yield curve is a graph that tracks earnings on all U.S. Treasury bills ranging from short- to long-term debt. The yield curve has been viewed as a simple forecaster of economic growth. In very general terms, a flat curve indicates weak economic growth, while a steep curve indicates strong growth. The yield curve also is thought to predict the Federal Reserve’s policy outlook. The Fed has recently pivoted to take a more dovish, or passive outlook, signaling there will not be further rate hikes this year and they anticipate only one rate hike next year. The yield curve is considered a predictor of the Fed’s policy and economic attitude.

How do investors utilize yield curve information?

Typically, investors are used to experiencing an upward sloping yield curve where bond investors believe they are likely to receive higher rates for longer term debt, over yields on shorter term debt. When investors perceive the economy is more likely to slow down over the short term (1-3 years), an inverted yield curve occurs, and long-term debts have lower yielding interest rates than short-term debt. When short-term yields are higher than longer term yields, borrowing costs in the shorter term are higher. In that case, businesses could find it more expensive to expand operations. Consumer borrowing also could fall, leading to a decrease in consumer spending. All of these factors could lead to a subsequent contraction in the economy and a rise in unemployment.

However, while there may be a tendency to assume that a recession is imminent because the Fed is dovish and the yield curve has inverted, recessions are difficult to predict. It is reasonable to believe the Fed has changed course to reduce the likelihood of recession. It is not necessary to panic. Inflation and high-risk trading remain low. History shows that Fed tightening (not necessarily inverted yield curves coinciding with tightening) may lead to financial crisis, transitioning into widespread credit crunches and resulting in recessions. It can be argued that credit crunches cause recessions, not inverted yield curves and aging expansions.

History tells us an inverted yield curve indicates a recession in about a year. The National Bureau of Economic Research showed that yield curve inversions have preceded each of the last seven recessions; however, there have been two notable exceptions: an inversion in late 1966 and a very flat curve in late 1998. Former chair of the Federal Reserve Janet Yellen recently explained that a yield curve inversion is historically an indicator of U.S. recession, though given current circumstances “it certainly doesn’t signal that this set of developments would necessarily cause a recession.” She further explained that “in contrast to times past, there’s a tendency now for the yield curve to be very flat,” which makes it much easier for the curve to invert. She also suggested there may come a point where the Fed would need to cut rates.

Moreover, the Cleveland Fed explained that while the yield curve is a good resource to use to predict whether future GDP growth will be above or below average, it is not as reliable at predicting an actual GDP number, especially in the case of recessions. With respect to anticipating an economic slowdown, as of March 28th, the Cleveland Fed predicted only a 33% probability of recession in the near future. The Cleveland Fed went on to explain that “it might not be advisable to take these numbers quite so literally for two reasons.” First, those calculations are statistical estimates, and therefore subject to error. Second, as other researchers have noted, “the underlying determinants of the yield spread today are materially different from the determinants that generated yield spreads during prior decades.”

It is important to note the yield spread has not inverted before every recession, and thus the lack of an inversion is no guarantee that all is well.

So, how should you consider the inverted yield curve in the context of your own investments? The bottom line is this: while it is important to be aware of the yield curve and analyze what it is doing and how it is responding as the U.S. and global markets are changing, it is not the sole factor to rely upon in determining when the next recession will be. While it is something worth discussing, wild speculations or extreme perspectives are not thoughtful responses to changes in the market. It is important to construct, implement and follow an investment strategy that you feel comfortable with, regardless of the ups and downs in the market. If you have questions or are concerned about your investment positions, you should seek guidance from your financial professional.