Does Yield Curve Inversion Matter For Investors?

The yield curve in the U.S. recently inverted. Normally, interest rates tend to increase as the maturity of U.S. Treasury bonds lengthens. However, if shorter rates rise above long term ones, that means the curve has inverted and can signal a future recession. However, there are a few considerations that may make yield curve inversion, or at least the inversion we’ve seen so far, less important than history suggests.

Brief Inversion?

Though the yield curve did invert recently, it may have been brief. At the time of writing, the yield curve is still pretty flat, but the 10 year yield is back above the 2 year yield. Now purists argue that the signal has already been given as its just necessary for inversion to occur, not for it to persist for a recession to be on the horizon.

A Glib Forecast

Saying a recession is coming may sound insightful, but without a firm date, it’s less useful. In a sense, there’s always another recession coming in the U.S.. Recessions appear to be an integral part of the economy.

Therefore, saying a recession is coming without being precise about when is less helpful than it may appear. In fact, yield curve inversion tends to lead recessions by about 6-18 months, again that’s a broad range, but a lot can happen during that intervening period. Often stock markets rise during this interval. Market timing is tricky at the best of times. Just knowing a recession could be coming fairly soon doesn’t necessarily help.

The market often prices in a recession before it occurs, so the stock market and the economy don’t track each other perfectly. The stock market is often a leading indicator, and of course many traders are watching the yield curve very closely. Many sectors of the market have fallen materially over recent months, part of that may be pricing in a higher recession probability for the U.S. economy as the Fed raises rates to tame inflation.

Other Metrics

Two other metrics have historically been important for yield curve inversion. First off, many experts think that the best thing to watch is the 3 month yield relative to the 10 year yield. That pair of rates has not inverted, though other parts of the curve have, if temporarily.

Secondly, it also appears that the depth of inversion may matter too. So far the inversion has been pretty shallow. That may be a positive sign.

Still, yield curve has a good track record when forecasting recession. In a way it shows us just how poor much of economic forecasting is. Yield curve inversion provides one of the relatively best recession signals, yet still has major limitations and drawbacks.