Recession Risks Rise As Yield Curve Flashes Major Warning

The yield curve has among the best records in predicting U.S. recessions. It hinted at a recession when it inverted in earlier in late March. Now the inversion is broader and deeper and if the Fed continue to raise rates, the inversion may become more pronounced. So we can be reasonably confident a U.S. recession is on the way.

An Impressive Track Record

Economists generally aren’t prized for their forecasting skills. The yield curve though has a strong track record in calling recessions. The term structure of interest rates, which is the difference between short and long bond yields, is among the best recession predictors. It has a remarkably strong post-war track record. According to Nicholas Burgess of Oxford University the yield curve has got a recession forecast wrong just once in the past 40 years. That’s impressive.

The yield curve is also a leading indicator of recessions since it calls coming recessions up to 18 months before they occur. So, all in all, the yield curve is historically among the best tools for forecasting a recession. When the yield curve inverts, you should worry. Unfortunately, currently it’s inverted, and if the Fed stays on course, that inversion worsen.

Interpreting The Data

The yield curve does provide a mass of information, changing minute by minute, so the New York Fed researched how best to interpret it in this paper. They found that the spread between 3-month and 10-year yields was most predictive of recessions, though it’s a pretty close call.

Ideally, in the researchers’ view, the spread should have a negative monthly average to predict a recession rather than just a temporary dip. It also appears that deeper inversion may make the signal more powerful. Not everyone agrees with that view completely, but most take the view that short rates rising above long rates does not bode well for the U.S. economy and deeper and longer inversion can make the signal more robust.

Looking Overseas

Recent research from the U.S. Treasury finds that foreign yield curves have forecasting power too for U.S. recessions, so if other yield curves are inverted that can reinforce the signal from the U.S. yield curve being inverted.

Currently, the Canadian yield curve shows some inversion, but yield curves in Japan and Europe are generally not inverted. Given that many central banks are expected to raise rates, hence raising the short end of the curve that may create inversion given the term structure of interest rates is quite flat currently. So there’s some hope looking internationally, but maybe not for long.

Why It Works

Like any good forecast there’s also two clear reasons why the yield curve works. Knowing this is helpful, as it means the forecast is less likely to be the result of meaningless number crunching.

Lending Policies

First when short term yields rise above longer term yields, that’s a big signal to banks. With an inverted yield curve, banks can make more profits from short-term lending, than from longer-term lending. That can mean pulling back on financing bigger, longer term projects such as new factories and other big investment projects. That sort of pull-back in the sort of investments that help economic growth is exactly what we see in many recessions.

The Fed

Secondly, what moves up the short-end of the yield curve is typically the Fed upping interest rates. They often do this late in the economic cycle when the economy may be starting to overheat. If we’re late in the economic cycle, that too can mean a recession is not far off. That’s exactly what’s happening now, high inflation and very low unemployment may be signs the U.S. economy is stretched currently.

Of course, we’re currently seeing one of the most aggressive patterns of rate hikes from the Fed in decades. Interestingly, the Fed knows about the yield curve’s forecasting power too, so there’s a chance they ease off on hikes precisely because of the yield curve’s inversion. They don’t want a recession either. However, for the time being rampant inflation appears the more pressing concern for the Fed. It’s not an easy call.

Breadth and Depth

You can see the latest U.S. Treasury yield curve data here. Currently it’s inverted from 6 month out to 10 year maturities. That’s relatively broad, and not a good sign for economic growth. In terms of the positives, the yield curve is fairly flat, so not deeply inverted. Plus that all-important metric of 10-year less 3-month maturities is not inverted yet.

However, we can be reasonably confident inversion there is coming soon if the Fed continues to hike short term rates as planned. Markets currently see the Fed raising rates around 2% over the rest of 2022, that’s almost certainly going create inversion of the yield curve when comparing 3 month to 10 year yields. Of course, this assumes the long-end of rates doesn’t move up much, but unless long-term inflation fears really take hold, that seems unlikely.

Final Thoughts

That the yield curve is signaling recession is not too surprising. Other metrics such as the current bear market, increasing talk about recessions, concerns about corporate earnings, early signs of weakness in housing and a softening jobs markets together with the observation that U.S. economic growth was negative Q1 all suggest that a recession may be on the way, or even already here (we’ll get Q2 GDP estimates next week, a current recession would be a surprise, but isn’t impossible).

However, as an investor it is important to remember that much of this may be priced in to markets. The very reason for weak stock returns over 2022 so far, may be the markets starting to adjust to a coming recession, or at least a reasonably mild one.

The severity of any future recession is important. When we talk of recession it conjures up memories of the Great Financial Crisis of 2007-8 and the pandemic recession of 2020. As the two most recent recessions, that’s understandable, but those were both unusually severe recessions in different ways and very painful for financial markets. So even if a recession is on the horizon, it may not be quite so disruptive as recent recessions imply.

Lastly, as of right now, the key metric of 3-month yields hasn’t inverted below the 10-year yield, many suspect that’s the most robust recession flag. There’s still some hope we could dodge the bullet. However, if the Fed remain on their current aggressive rate trajectory, we may see that invert in later this year based on current interest rate futures.