Inverted Yield Curves and Recession

By Neil Chapman, JD, CFA
Director, Chief Investment Officer

If you are invested in the stock or bond market, or watch financial news, you likely know that the yield curve inverted on Friday, April 1st, although it technically inverted on an intraday basis the previous day. It was no April Fool’s joke, but rather a highly anticipated event for market participants and observers. Since the 1970’s, a yield curve inversion has occurred before every recession, so it was no surprise that the financial media’s attention turned to talk of a recession. As market participants struggle to determine the fair value for stocks and bonds in a challenging environment, the possibility of a recession adds one more uncertainty to the equation.
 
What is a yield curve, and what is an inverted yield curve?

Before we discuss the possible meaning of an inverted yield curve, we need to define a few terms. A yield curve, a Treasury yield curve in this case, is a graph which shows the yields of Treasury securities of different maturities. A normal yield curve slopes upward, with shorter-maturity Treasury securities having a lower yield than longer-maturity Treasury securities. An inversion occurs when the yields of shorter-maturity bonds exceed those of longer-maturity bonds.
 
One measure of the yield curve, and the most common measure discussed in financial literature, is the difference between the yields on the 10-year and 2-year Treasury bonds (10-year yield minus 2-year yield), often called the “2-10 spread.” When the difference is negative, meaning the 2-year yield is higher than the 10-year yield, the yield curve is inverted. This inversion occurred on April 1st. As mentioned previously, and shown in the graph below, this yield curve inversion (negative spread) has preceded every recession since the 1970’s. For the truly discerning observer, the curve technically inverted in 1998 without a recession in the predicted time frame. It should be noted that it was a small (-.12 at its lowest level) inversion over several days. A similar inversion occurred in 2019, and although a recession followed, it is very debatable as to whether it predicted the pandemic-related recession.

​Why is the inverted yield curve a good predictor of recession? 
 
While there is no definitive explanation for why an inverted yield curve is predictive of recession, there does seem to be a generally accepted, somewhat intuitive, explanation. Briefly, that explanation is as follows:  The shape of the yield curve contains information about the current and expected interest rates over time. The interest rate on a longer-term bond in part reflects the path of short-term interest rates expected over the life of the bond. The path of interest rates is influenced by market participants’ view of economic activity and monetary policy (the Fed). If market participants see an economic downturn, or recession, they are likely to anticipate that the Fed will cut rates in the future to provide monetary accommodation. This will reduce longer-term rate expectations and cause a curve inversion.  A related explanation is that market participants expect an aggressive Fed to raise interest rates, causing current rates to rise relative to longer-term rates (recall that the Fed controls short-term interest rates). This could cause the curve to invert. Raising short-term rates generally increases the odds of a future decline in economic activity, and the inverted curve signals the possibility of future recession.
 
Is the 2-10 spread the best measure for predicting recessions?
 
As previously mentioned, the 2-10 spread is commonly used as the indicator for predicting a recession.  Several studies over the years have shown this spread to be a valid predictor of recession. Research has shown, however, that there are at least two other spread measures that are predictive of recession.
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Several studies have shown that the spread between the interest rates on the 10-year note and the 3-month Treasury bill is also predictive of recession. One such study showed that this spread is a valuable forecasting tool in predicting recessions 2 to 6 quarters ahead. Moreover, this spread outperformed other financial and economic indicators, such as stock prices, the Conference Board’s index of leading economic indicators, and the Stock and Watson leading indicators, in predicting recessions (Estrella & Mishkin, FRB of NY, June 1996).
 
In 2019, the authors of a research paper introduced a brand-new spread measure and compared its power to predict recession with the 2-10 spread and the 3mo-10-year spread (Engstrom & Sharpe, Federal Reserve Board, Washington, D.C., 2019). This new measure is called the “near-term forward yield spread” and is defined as the difference between the implied interest rate expected on a 3-month Treasury bill six quarters ahead and the current yield on a 3-month Treasury bill. The evidence showed that this new measure was statistically superior to the other two measures for predicting recessions.  The graph below compares the 2-10 spread with the near-term forward spread, showing that the near-term forward spread was more pronounced (negative) before recessions. The research also showed that the 3-mo-10-year spread generally fell between the 2-10-spread and the near-term forward spread in terms of its predictive power.

​Generally, the authors showed that the predictive component of yield spreads is highly correlated with market expectations for monetary policy over the coming several quarters. The near-term forward yield spread can be interpreted as a measure of these market expectations for the trajectory of conventional near-term monetary policy. Interestingly, the research also showed that the near-term forward spread predicts 4-quarter GDP growth with greater accuracy than survey consensus forecasts and that it has substantial predictive power for stock returns.
 
What does the current yield curve tell us about a potential recession?
 
As previously noted, the yield curve, based on the 2-10 spread, inverted on April 1st. The curve inverted for only 2 days, with the lowest reading being -.05. This inversion appears very similar to 1998 and 2019, when a very brief and small inversion did not signal a recession. The 3-mo-10- year spread did not turn negative in April, nor did the near-term forward spread. Therefore, none of these yield curve spreads are currently predicting a recession. Additionally, looking at the chart below, we can see that the near-term forward spread was moving in the opposite direction of the 2-10 spread at the end of March.   

​How can an investor use this information on inverted yield curves?
 
The research regarding yield curves generally shows the following: the 2-10 spread is a good indicator of a future recession, the 3-mo-10-year spread is a better indicator, and the near-term forward spread is the best indicator. These indicators are predictive of a recession occurring in approximately the next 4 – 6 quarters. Additionally, any inversion should last for more than several days, even if it is not large in magnitude, to be considered a recession signal.  
 
Investors, however, should also take note of two other observations found in the studies and research.  First, no spread measure is perfect in predicting a recession, so a spread measure should always be used in conjunction with other economic indicators. Second, monetary policy expectations are a large part of the explanation as to why the inverted yield curve predicts recession. Since the Great Recession, the Fed has played a much larger role in the financial system, especially in the fixed income market with its Treasury bond purchases. This increased Fed activity is likely the cause of the flatter yield curve that has existed since 2014, making inversions somewhat more likely (Economic Brief, FRB of Richmond, December 2018).