Yield Curve Inverts To Historic Lows, Sounding Recession Warning

The yield curve has a great historical track record in predicting U.S. recessions and it’s signaling one’s coming. The 10-year Treasury bond now yields more than 1 percent less than the 3-month bill. That’s unusual, in fact, it’s lower than we’ve seen at any point in the last 30 years. It’s been a historically robust indicator that a recession is coming. Yet, in contrast to this stark warning, the jobs market remains robust.

Slope Of U.S. Yield Curve

The Yield Curve As a Recession Indicator

The New York Federal Reserve (Fed) summarizes the research on the yield curve as a recession indicator here and finds that the U.S. yield curve is a historically reliable signal that a recession is coming on a 12-month view.

As of early December, the New York Fed put the chance of a recession in the U.S. over the next 12-months at approximately 40%. That’s relatively high, but since then the yield curve has inverted further, and it’s likely that the next update will show a far greater recession probability, perhaps with a recession more likely than not.

The Jobs Market Does Not Agree

However, the jobs market is not following the script that the yield curve suggests. U.S. unemployment for December 2022 came in at 3.5%. That’s also approaching lows we also haven’t seen in decades, but is much more positive for the economy. Of course, the jobs market could change rapidly, but we haven’t seen that yet.

U.S. Unemployment Rate

Why It Works

The yield curve might work as a recession indicator for two main reasons. The first is that if short rates are much higher than long rates, as they are currently, then financial intermediaries, like banks, have little incentive to lend for the long-term. They can make shorter term loans and potentially see greater profits. That may mean less funding for the sort of long-term projects that can spur economic growth.

The second reason is that for short-term rates to be high, it’s likely that the U.S. Federal Reserve is hiking interest rates. That’s exactly what’s happening now. Unfortunately, though it’s not their intent, often when the Fed hikes rates, that can slow economic growth, causing a recession. Now, this cycle could be different and the Fed don’t expect a recession currently, especially given the strong jobs market, but it’s historically been hard to avoid a recession when the Fed starts raising rates aggressively.

Priced In?

If a recession is coming, what does that mean for markets? A recession may not be too much of a surprise. Some argue the decline in markets in 2022, priced in recession risk. Others argue that the bear market of 2022 was just a reaction to rising rates and there’s more downside to come if a recession hits. Certainly, much depends on the duration and severity of any U.S. recession, should it occur. Still many more economically sensitive sectors of the market, such as housing sold off dramatically in 2022.

Of course, the yield curve could be wrong. It’s built up a strong track record over history, but their have been many unique events during this economic cycle, and maybe a false alarm from the yield curve could be another one of those. Nonetheless, it should not be ignored that the yield curve has a robust historical track record and is showing a very strong warning that a recession will be here soon.