Why a U.S. Yield Curve Inversion Worries Recession Watchers

By: Dave Roos  | 

Stock Market Candlestick Financial Analysis Abstract
A volatile stock market and an inverted treasury yield curve. Does that mean recession is on the horizon? filo/Getty Images

Economic speculation can often feel like a self-fulfilling prophecy. When confidence in the economic future is high, the markets and the broader economy hum along. But when investors, banks and businesses get nervous, money stops flowing and the whole system grinds to a halt. That's called a recession.

The United States economy has been riding the longest bull market in history, posting record stock market gains and historically low unemployment figures, despite volatility from inflation and the COVID-19 pandemic. But the fact is, recessions happen and it's been more than 10 years since the last one officially ended. While some analysts say the economy is not technically "due" for another market correction, many analysts say the economy is dangerously flirting with correction territory.

But one of the clearest indicators that a recession might be just around the corner is a wonky graph called the treasury bond yield curve. As we'll explain, this single marker may be the king of all self-fulfilling prophecies, successfully predicting at least seven U.S. recessions.

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What Is the Treasury Bond Yield Curve?

So what exactly is the treasury bond yield curve? The U.S. federal government sells Treasury bonds to investors as a way to borrow money. Treasury bonds are considered the safest investment in the world, because they're backed by the U.S. government, but they also carry relatively low interest rates. In general, the demand for Treasury bonds goes down when the economy is doing well and goes up when the economy is sluggish. That's because investors are willing to take risks on higher-yield investments when the economic future looks bright. Investors tend to come back to bonds when they need a low-risk safe haven.

Treasury bonds come in a variety of "flavors" or different maturity dates. You can buy short-term T-bills that mature in three or six months, or long-term bonds that won't fully mature for 10 or even 30 years. Normally, the short-term bonds will have lower yields or interest rates than the longer-term bonds, because a longer investment carries more risk that inflation will eat up your gains over time. So if you plot the yield of Treasury bonds on a graph, it will normally curve or slope upward, with progressively higher yields for bonds with two-year, five-year, 10-year and 30-year terms.

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When the Yield Curve Flips

But in economics, things aren't always normal. Every so often, that yield curve flips upside down, with short-term bonds posting higher yields than long-term bonds. And historically, when that happens, a recession is imminent. The yield curve flipped in 2005/2006 as well as in 2000, 1988 and 1978, prefiguring the recessions that followed in the next year or two. The only time the yield curve inverted without preceding a recession was 1998.

So why exactly does the yield curve turn on its head? This gets to the self-fulfilling prophecy part. Bond prices and yields fluctuate according to investor demand. When more investors and companies want to buy long-term bonds, the price goes up and the yield goes down. As we mentioned, when economic prospects look good, fewer investors want to bury their money in a relatively low-yield, long-term bond. But if the future looks shaky, as it does for some investors right now, they start to flock toward these low-risk bonds, driving prices up and yields down even further.

On the other end of the graph, short-term bond yields have been pushed higher by the Federal Reserve, which has been slowly raising short-term interest rates in an effort to rein in an overheated economy. Then, as demand for those short-term bonds slows, it pushes their prices down and their yields even higher. The result is a "flattened" yield curve.

But the yield curve can also invert. On March 31, 2022, the yield on the 10-year Treasury note briefly fell 0.03 basis points below the two-year note before it bounced back above 0 to 5 basis points. This was the first time since 2019 the yield curve inverted. On Aug. 14, 2019, the yield on the 10-year Treasury note was 1.4 basis points below the two-year note, causing a massive drop in stock market prices. By Aug. 16, 2019, the curve was no longer inverted and the stock market climbed.

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What Does An Inverted Yield Curve Mean?

So why does an inverted yield curve have recession watchers so worried? Because it's a sign of lagging investor confidence that can have real effects on the flow of money into the economy.

Jeroen Blokland is the founder of True Insights, an independent investment research platform focusing on global multi-asset portfolios. He says one of the reasons for concern is because inverted yield curves have forecast the last six recessions. He also believes the Federal Reserve System was too far behind the curve in thinking that the current high rate of inflation would be temporary.

"To get back ahead of the curve and restore credibility, [the Federal Reserve] has to tighten aggressively to slow inflation," Blokland says via email. If the yield hits the neutral rate, which is somewhere around 2.5 percent, it will start to impact gross domestic product growth, Blokland says. Most of the time this signals lower, not higher longer-term bond yields, and often a recession.

Also, when capital is tight, businesses shelve new projects, freeze hiring or even lay off employees to cut costs. When workers are nervous that they're going to lose their jobs, they're less likely to buy cars or build new houses. Slowly but surely the economy loses steam, unemployment grows and we're back in a recession.

Blokland notes that an inverted yield curve doesn't mean that a recession is arriving tomorrow, but the odds of one coming are high. "I would be cautious in stating this time is different. One could argue that the 10-year, three-month yield curve has not inverted, but that one tends to invert after the 10-year, two-year curve," he says. "So I would put the odds of a recession at 50 percent or higher."

So what does this mean for the average investor? If too many think that the economy might fall into a recession and start moving their money into other places, that could fuel the self-fulfilling prophecy.

"Selling your equities automatically when the yield curve inverts is not the best strategy," Blokland says. "My general idea would be not to get too negative, but instead be a bit more cautious when [we] pass 12 months after this inversion." Ironically, he says, risky assets and equity markets, in particular, tend to go up just until the recession arises. And the increase between yield curve inversion and recession is significant.

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Originally Published: Dec 14, 2018

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