The Yield Curve Is Sending A Recession Warning | ETF Trends

In this article, I focus on the Treasury yield curve, which is sending its sharpest warning about recession risks since 1981.

The Fed and Yields

The Fed took decisive action to combat runaway inflation. The upper bound of the Fed Funds rate was raised from 0.25% to 5% in nine rate hikes, pushing borrowing costs to the highest since 2007.

Fed Funds Rate, 25 Years

Longer-term yields, which are set via market trading in Treasury notes, also rose but lagged the upward pace of short-term yields. The benchmark 10-year yield fluctuated above 3.4%, currently 3.6%:

10-Year Treasury Yield, 1 Year


The Yield Curve

Thus, the 10-year yield is now trading significantly below short-term yields (3-month at 4.88%). Normally, yields for long-term bonds stay above short-term (a “normal” curve) most of the time as their higher risk, in theory, requires higher return. Long-term yields trading below short-term is called an “inverted curve.”

Source: US Treasury

The difference, or spread, between the 10-year and 3-month yields (the blue line on the chart), and the 10y-2y spread (the purple line), both have reached around -1% – the largest inversion since 1981. It only reached lower levels twice, in 1980 and 1981 (because the absolute level of Treasury yields was much higher then).

Yield Curve Spread, 1962-2023

An inverted yield curve preceded all eight U.S. recessions since the beginning of market trading in Treasury securities. The lead time between the inversion and the beginning of a recession ranges from immediate (in the 1970s and 80s) to nine months (the 2008-09 recession). A false signal was given in 1966, when a recession didn’t occur after a 3m inversion, and in 1998 when a very small, 0.05% 2y inversion occurred for a brief month. Before the 1990 recession, only the 2y inversion occurred but technically, not the 3m (although it was very close).

The magnitude of the inversion doesn’t seem to matter, as long as at least one significant (larger than 0.05%) inversion lasts for longer than a month. For example, inversion reached 38 basis points on 3/31/2007 as the mortgage crisis was unfolding and before the 2007-09 recession and bear market. It reached 53 bps on 12/31/2000, before the 2001-02 bear market and recession.

A 3m inversion occurred even in mid-2019 and preceded the 2020 bear market and recession, even though that downturn was arguably caused by an exogenous event – the COVID-19 pandemic. However, the economy was weakening in late-2019, and it’s unclear if a recession would have followed anyway.

This brief review confirms that the yield curve inversion is historically a very reliable indicator of an upcoming recession.

The Way Forward

The yield curve can normalize if short-term yields (which follow closely the Funds rate set by the Fed) fall below long-term. It typically occurs as part of an economic contraction, falling demand, and a collapse in prices (deflation). By that time, the Fed might be forced to lower the Funds rate.

Considering the Fed’s current focus on combatting inflation, short-term rates/yields can only decline when the Fed wins the fight against inflation. This will happen when demand falls so much as to cause a drop in consumer inflation (currently still high at 6%).

The Fed is fully aware, and in fact expects, that it might take a recession to win against inflation. Fed chairman Powell openly warned in his Jackson Hole speech in November-2022 that “hard times for families and businesses” (the “Fed speak” for a recession) are likely to result from its tightening policy. His hawkish public remarks support this view.

While the yield curve is not the only predictive indicator, its long-term track record is compelling. The large yield curve inversion signals that a recession is very likely, probably as soon as this year. A recession will be very negative for the stock market as the economy’s forward-looking barometer.

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