Recession Alarm Just Sounded By Yield Curve Indicator With Stellar Track Record

U.S. government 3-month rates rose above the yield on 10-year bonds according to U.S. Treasury data for October 18, 2022. This is a fairly unusual and researchers regard this as among the best indicators that a U.S. recession is coming on a 6-18 month view. This indicator has among the best track records in forecasting recessions across a range of economic variables. It has successfully called all recessions in recent decades without any false alarms. That’s impressive, and among a sea of indicators, this one deserves some attention.

Yield Curve Inversion

The U.S. yield curve measure the ‘shape’ of yields on U.S. government debt as maturities increase. Typically as you hold U.S. debt with a later maturity you receive a higher interest rate compared to shorter rates.

This means that U.S. yield curve has generally had an upward slope. However, sometimes short rates can rise about longer rates and the curve slopes downward. That’s inversion.

Yield Curve Trends in 2022

We’ve seen increasing yield curve inversion in 2022 as the U.S. Federal Reserve (Fed) has pushed up rates. Yesterday, the 3 month rate nudged above the 10 year rate for the first time since before the pandemic (and yes, the yield curve predictive the pandemic recession too). That change inverted what many regard as a critical relationship in the U.S. yield curve, signaling a coming recession.

The Evidence

The yield curve is well studied given its strong track-record and there are various ways to interpret it, but researchers at the New York Federal Reserve suggest that the 10-year rate less the 3-month rate is likely among the best indicators of a coming slowdown in economic activity. That’s the relationship that just inverted.

Then there’s debate as to whether a single inversion is sufficient or whether sustained or deeper inversion can provide a more powerful signal. However, we currently have a yield curve that is highly suggestive of a U.S. recession, with further rate hikes on the cards, if the 10-year bond doesn’t see higher rates soon, then inversion could deepen as we close out 2022.

Why This Indicator Has Worked

Aside from the historical relationship with recessions there are a few reasons why yield curve inversion may have predictive power.

The Fed

The first is that for the yield curve to invert the Fed is typically raising short-term rates, just as we’ve seen in 2022. Typically the Fed’s actions in raising interest rates can reduce economic activity and that can cause a recession.

Indeed, the Fed’s current language, and likely plans to hike rates again by 0.75 percentage points in early November, suggest they are extremely concerned about rampant inflation. A recession is certainly not the Fed’s goal, but may be a less bad outcome for the U.S. economy than entrenched inflation, based on recent Fed statements. Therefore, inverted yield curves often occur when the Fed hikes rates, and that can cause recessions.

The Banks

Secondly, inverted yield curves can change the behavior of banks and other lenders. With an upward sloping yield curve banks can receive more interest lending for long-term projects, such as a new factory or other forms of economic expansion.

With an inverted yield curve that picture changes. It is actually may be better for banks to engage in shorter-term lending, potentially making less capital available for the sort of longer term projects that can fuel economic growth.

The Risks

The yield curve is pretty good historically, but not perfect. Going back to the 1980s the track record of yield curve inversion is basically perfect in calling recessions, but if you go further back you can find some false signals, and recessions aren’t all that common.

The fact that the yield curve is a leading indicator of recession can also make it slightly vague. We suspect a recession is coming, but we don’t know precisely when, and some argue we may already be in one.

Market Timing

If you are using the yield curve to time the stock market it gets a lot more complicated. There are various reasons we are in a bear market today, and the prospect of a recession is certainly one of them.

Therefore, the prospect of a recession is not necessarily news to financial markets, especially in the current environment. In fact, often historically the stock market has bottomed before a recession ends. The yield curve may cement out conviction that a recession is coming, but that may not necessarily give you an edge in the markets.

Increased Attention

It’s also noteworthy that the yield curve indicator is getting more attention. The Fed may reference yield-curve inversion in their decision-making as may market watchers. There is now more reaction to the yield curve directly, that may impact its forecasting value compared to times when it received less attention.

The recent inversion of 3-month and 10-year rates, provides a strong signal of a near-term recession. That signal may reinforce the recession risk that many already see. Nonetheless, the historic power of this indicator does mean it should be taken seriously.