The US yield curve is frequently used as a predictor of recessions. When the yield curve inverts, this tends to suggest that a recession is on the horizon. However, this isn’t always the case. Assessing the history of yield curve inversions, we can better understand how frequently they’ve correctly forewarned of recessions. Importantly, we can assess the current shape of the curve and what this might mean for the global economy.
The yield curve depicts the amount of compensation the US government will give investors for buying treasury bonds of different maturities. Simply put, buying a $100 bond with a 1-year maturity is the same as lending the US government $100 and receiving $101.92 back at the end of the year. Likewise, if you bought a 30-year bond, you would receive 2.52% per year, plus your initial $100 after 30 years – the longer the “loan”, the more an investor should generally be compensated for it.
For normal curves, yields on shorter maturities are lower than yields on longer maturities. As per our example, the 1-year rate is less than the 30-year rate. However, when short-dated yields are higher than at longer maturities, this is called curve inversion. Specifically, the curve is considered to be inverted if the 2-year yield is higher than the 10-year yield. Inversion happens when investors at the long end of the curve (10-year +) pre-empt Federal Reserve rate cuts (in anticipation of a weaker economy), buying up bonds with higher yields than are expected in future. This then pushes long yields lower.
The chart below depicts the steepness of the yield curve. When the difference between 10-year and 2-year treasuries is lower than zero, the curve is inverted. The red dots on the curve depict inversions without a recession, while the green dots show an inversion which was then followed by recession. Evidently, since 1962, yield curve inversions are followed by recessions more frequently than they aren’t – of the 9 inversions, 7 resulted in recession.
Therefore, many market commentators have highlighted how close the current yield curve is to inversion – if the curve inverts, they say that recession is likely to follow. Figure 2 shows the difference between the yield curve in 2013 and now.
In 2013, the 2-year yield on treasuries was 0.38% and the 10-year yield was 3.04% – illustrating a relatively steep curve. Since then, the curve has flattened, with 2-year yields currently at 1.75% and 10-year yields at only 2.00%. While the difference between the 10-year and the 2-year curve is now only 0.25% vs. the 2.66% of 2013, the curve is not yet inverted. Therefore, while a further flattening of the yield curve could well imply an impending recession, we aren’t there yet.