A section of the U.S. Treasury yield curve inverted last week, setting off speculation about whether the indicator is a signal of a coming recession or merely an abnormal blip caused by technical factors.
As Reuters reported, yield curve inversions — when shorter-term securities yield more than longer-term securities — have preceded every U.S. recession in recent memory by 15-24 months. In the most recent case, yields on five-year notes have dropped below those on both two-year and three-year securities.
An upward sloping yield curve, where longer-term securities yield more than shorter-term securities, is generally consistent with a growing economy. As the economy slows, demand for longer-term securities increases as investors look to lock in higher yields before the inevitable decline in yields that occurs during recessions. This higher demand leads to lower rates and a flattening, and potential inversion, of the yield curve. Another contributor to a flattening yield curve is when the Federal Reserve raises short term interest rates to prevent overheating of the economy. The Fed has increased rates eight times since the end of 2015 and is likely to increase them again when they meet later this month. Historically, the shape of the yield curve has been a reliable indicator of the strength of the economy.
It is important to note that not all inversions have led to a recession, but recessions have always been preceded by inversions. This makes inversions a far-from-flawless predictor.
As Jefferies’ chief global equity strategist Sean Darby told Bloomberg: “The general rule is that an inverted yield curve indicates a recession in around a year’s time, and that yield curve inversions have preceded each of the last seven recessions. However, the yield curve is not perfect, as there have been two notable ‘false positives’ — an inversion in late 1966 and a very flat curve in late 1998.”
In recent economic downturns, the more reliable indicator has been the gap between two-year and 10-year Treasuries, which is at 14 basis points — its flattest level since 2007 but not inverted. The general consensus is that if the two-year yield rises above the 10-year yield, such an inversion would be a signal of a potential recession.
The yield curve is certainly flat by historical standards and may even invert. However, this does not necessarily mean a recession is around the corner. Typically we need to see weakness in other measures, such as job losses and credit deterioration, before a recession is imminent. However, these measures remain strong, as does the consumer, which drives nearly 70% of the economy. Correlation of yield curve inversions with recessions does not equate to causation. We remain vigilant in looking for additional signs of recession, and in the meantime, are taking advantage of the movement on the shorter end to invest at higher yields for our clients.