Many investors have started to scrutinize the shape of the US Treasury yield curve, worried that a potential yield-curve inversion would mean imminent recession. In our view, things aren’t that simple.
The yield curve has flattened considerably since the Federal Reserve began raising short-term interest rates. Long-term rates aren’t rising nearly as fast, leaving 10-year US Treasury yields only about 0.25% higher than two-year yields.
In past economic cycles, an inverted yield curve—with 10-year yields dropping below two-year yields—has preceded recessions. If the yield curve does invert in the near future, does it mean trouble is right ahead for the US economy, or could this time be different?
A Useful Signal—But Certainly Not a Perfect One
The logic behind the inverted yield curve as a recession indicator is simple: if long-term yields are lower than short-term yields, the market’s view is that growth will slow in the coming years. More often than not, that view has been right. An inverted curve has preceded every recession in the post-WWII era.
But the track record is by no means perfect (Display).
In some cases, the US yield curve inverted but wasn’t followed by a recession. In the late 1980s, for example, the yield curve inverted and then steepened again, before inverting again later on before recession. The curve also inverted very briefly in the late 1990s, too, and again in 2005–2006.
Even when a recession does happen, the amount of time before it starts has varied widely: sometimes it’s taken nearly two years and sometimes only a handful of months. So, even if investors believe that the shape of the yield curve is a powerful predictor of recessions, it’s not exactly a strong trading rule.