Deepest yield curve inversion in 40 years: will there be a recession?

“Inverted yield curve” is a phrase which has taken on an almost mythical quality in financial markets over the years. Bonds are currently spelling doom, but it’s not as easy as it seems. So let’s dig into what it all means. I’ll try to answer three questions here:

1. What is an “inverted yield curve? 
2. How accurate has it been at forecasting recessions?
3. Will there be a recession soon? 

What is an inverted yield curve?

First things first. The yield curve simply represents the different yields available on bonds of different maturities. And here, we will focus on US government bonds, which are the most common point of reference. 

Typically, longer-maturity bonds pay a higher yield. This makes intuitive sense, as the longer you hold a bond, the more risk you bear, and hence the higher yield you should scoop as compensation (I’m simplifying here, but that is the high level). 

However, an inverted yield curve describes a situation where the long-term interest rates are lower than short-term interest rates. And the legend goes that it is a good predictor of recessions (more on that later). 

The short-term interest rate is commonly set by a country’s central bank. In the US, this is the Federal Reserve, which sets what is commonly known as the Fed funds rate. This is the interest rate around which everything in the economy is priced. When the Fed hikes the rate, as it has done over the last year, the increase flows through to all borrowing in the economy – mortgages, credit card debt and so on. 

Longer-term interest rates are a little more nuanced. They, like any rate, are affected by the Fed’s decisions, but these rates are also heavily influenced by market rates. This is because, due to the longer time frame, there is an implicit forecast of what rates will be in the future. 

For example, if short-term rates are low (as they had been since the 2008 Great Financial Crash, until recently), then the market may forecast higher inflation in future. Accordingly, longer-term interest rates will be higher to compensate bondholders for the potential loss of purchasing power. This can result in a steep yield curve. This is a somewhat extreme – but topical – example, and general the yield curve’s “normal” shape is upward sloping anyway.

On the contrary, if interest rates are high but the market expects them to come down in future, today’s long-term interest rate could actually be lower than the short-term interest rate. This is the situation we currently find ourselves in: an inverted yield curve. Not only is the yield curve inverted, it is the deepest inversion in 40 years. 

Does the yield curve forecast recessions?

The 10-year / 2-year yield curve has often inverted before recessions historically, as the previous chart shows. Other maturities are sometimes compared, but the 10Y – 2Y is the one which has shown the most predictive power, and I will focus on here. 

The large gap in 1980 is obviously notable, but the curve was also prescient more recently – inverting ahead of the dot com bubble (2000), the GFC (2008) and… now. But it is not so simple so as to declare the yield curve as a crystal ball for recessions. 

If you’re eagle-eyed, you will see there was a quick inversion in 1998 when Russia defaulted on its debt, but a recession never came (as the Fed stepped in quickly to cut rates). And in August 2019, there was a similarly brief dip, only for the curve to be back to normal within a few months, a recession nowhere to be seen. 

But overall, the record is seriously impressive, especially when ignoring the swift inversions which were quickly resolved. In fact, over the last 40 years, every single time the  2-year yield has been above the 10-year yield for longer than six months, a recession has followed. 

As for the timing, this has varied, but in the same time period, a recession hit between 12 to 18 months after the yield curve inverted. The inversion in January 1989 preceded a recession commencing 18 months later in July 1990, the inversion in Feb 2000 preceded the (dot-com bubble) recession 13 months later in March 2001, and the GFC recession kicked off in December 2007, with the yield curve inverting 14 months prior.

But what about today? The yield curve inverted in July 2022, nine months before I am writing this piece. For the record, it very briefly inverted slightly in April 2022, but swiftly pulled back, and we know from earlier that brief inversions are not as powerful. However, it inverted again in July and has been negative ever since. Not only that, but it has become the deepest inversion since 1981. So, should we be worried?

Will there be a recession?

While the curve is forecasting a recession, the more interesting question from an investor’s point of view is how this will affect asset prices. And for this, the inversion is a lot less powerful, because of the concept of events already being priced in. 

A recession could come – indeed, this is the feel of a lot of the market currently – but this could already be incorporated into asset prices. We saw this in 1989, when the yield curve inverted in January but the S&P 500 increased 27% that year (before falling 6% in 1990 and then rising another 26% in 1991). 

In reality this is what makes markets so difficult. Stock prices trade with future information baked in, at least to the best of the market’s ability. It is the concept of an efficient market which I have talked so heavily about. 

As crazy as it is to say, stocks don’t always fall during a recession. Sometimes they fall before it, and the yield curve inverts in anticipation of the recession. In that case, it can almost be viewed as a recession slowly coming to the fore and driving the yield curve into inversion, rather than the curve itself forecasting a recession. 

It’s all getting a bit philosophical, but the point is that nobody really knows. If a recession does hit, it could be a brief and relatively painless one, or it could be a long and daunting pillage of the economy at large. No two recessions are the same, and the yield curve doesn’t help us much with trying to pinpoint which will be worse than others, nor what will happen. “Recession” is a very broad category.

Today, stock prices could have already adjusted to this potential for recession. 2022 was the worst year in markets since 2008, with the Nasdaq shedding a third in value and the S&P 500 losing nearly 20%. While 2023 has been kind for investors thus far, most asset prices are still down significantly from 2021. 

Timing the market is ever-so-difficult, and if you are looking for a simple get-rich-quick-scheme like “short the market when the yield curve inverts”, you’re living in fairyland. 

A favourite phrase during the pandemic was “these are unprecedented times”, overused to the point of madness. But today in economic terms, these really are unprecedented times. We have still-high inflation, a Fed claiming they will continue hiking, but a market betting that the tight monetary policy is all but over. 

Throw in the recent banking wobbles and the war in Ukraine, and it’s almost impossible to keep track of all the messy variables right now. As always, it’s not the sexiest answer, but with the weight of history and maths pulling in one direction, dollar-cost averaging may just be the easiest, and most correct, way to play it.