Yield Curve Inverts To Depths Not Seen Since 1980s, Raising Recession Fears

After trending lower throughout 2022, the yield curve is now deeply inverted. The 10-year U.S. Treasury yield less the 2-year yield now stands at levels not seen since the 1980s. This is a concern because this is a well-regarded indicator of a coming U.S. recession. The yield curve has a strong track-record in predicting recessions with very few false positives over recent decades.

U.S. Treasury 10 Year Yield Less 2-Year Yield 1976-Present

What It Has Worked

Yield curve inversion often predicts U.S. recessions, because it may play a role in causing them. If short-term interest rates exceed longer term rates, then it doesn’t make sense to lend for the long term. Instead, banks, and other financial intermediaries, can achieve better returns making short-term investments. That can cause overall investment to decline because many projects require long-term funding and those may get cut. That in turn, can reduce growth.

In addition, the yield curve often inverts when the Federal Reserve hikes interest rates, just as they are doing currently. That too can push the economy into recession. The Federal Reserve is aware of this risk, but is currently focused on reducing inflation.

Is A Recession Coming?

The yield curve has a strong track record, but it’s not perfect. The timing of the yield curve signal though historically accurate, is somewhat vague. Most argue that an inverted yield curve implies a coming recession within 12-18 months. That’s a far better record than many forecasters and forecasting tools, but still imprecise.

Research by the New York Federal Reserve puts the chance of a recession in 12 months based on the yield curve at 38% currently. That may not seem that high, but it’s a lot higher than its been over the past several years, excluding the 2020 pandemic, when the yield curve managed to a recession too.

Still a better indicator for being in a recession, may be economist Claudia Sahm’s insight that if the 3-month average of unemployment moves 0.5% above the 12-month low, then we’re likely in a recession. We’re not there yet.

However, the advantage of the yield curve may be that it is a leading indicator, knowing about a recession before it comes can be helpful. Lots are signals are suggesting a chance of a recession arriving soon, but the yield curve may be among the most credible.