What is an inverted yield curve? U.S. has seen one before every recession since 1955.
Medora Lee, USA TODAY
5 min read
Nowhere in financial markets has the world seemed more upside down than in the bond market this year.
First, usually, when stock prices drop, Treasury bond prices rise as investors flee risky assets to safe government-backed securities. But with soaring inflation and the Federal Reserve late in trying to contain it, bond prices have tumbled with stocks, killing investors holding the traditional, moderate risk 60% stock,40% bond portfolio. High inflation erodes bond returns, making them less attractive.
Then, when the Fed started raising its benchmark interest rate to dampen demand to cool inflation, investors hoped the Fed could do so without plunging the economy into recession. But when May consumer inflation accelerated at the fastest pace in 40 years, panic set in. The Fed boosted rates at its next meeting by 75 basis points, the largest since 1994, and said more of those might come.
That, coupled with data showing the economy’s cooling quickly, has triggered worries the Fed in its commitment to lower inflation might end up raising rates too fast and too aggressively.
This has all turned the bond market upside down. Yields on 2-year notes are now higher than on 10-year notes, resulting in what’s called an inverted yield curve and could be cementing odds for a recession.
A yield curve is a graphical representation of the interest rate or yield, (the vertical axis) paid by government debt at different maturities (the horizontal axis). The Treasury market consists of bills that mature in one month to one year, two- to 10-year notes, and 20- and 30-year bonds.
In normal times, the curve steepens or rises, because of higher payouts on longer-dated debt. Longer maturities tend to carry higher yields because there are inherently higher risks associated with holding an asset longer. Simply, there's just more time for that investment to go sideways.
The yield curve is often seen as a bond market measure of confidence in the economy. A steepening yield curve suggests the economy will do well, naturally leading to some higher inflation, and higher interest rates. Modest, predictable inflation is seen as part of a healthy economy.
FILE - In this July 30, 2019 file photo, trader Gregory Rowe works on the floor of the New York Stock Exchange. An economic alarm bell is sounding in the U.S. and sending warnings of a potential recession. Yields on 2-year and 10-year Treasury notes inverted early Wednesday, Aug. 14, a market phenomenon that shows investors want more in return for short-term government bonds than they are for long-term bonds. (AP Photo/Richard Drew)
What does an inverted yield curve predict?
A negatively sloped, or inverted yield curve happens when yields on shorter-term maturities rise above those on the longer end. Analysts usually focus on the difference between rates on the two-year notes and 10-year Treasuries.
Inversion suggests investors expect higher rates now (like we're seeing now as the Fed is in a rate hiking cycle) and lower rates later. Because central banks generally cut key rates to stimulate demand in a flagging economy, expectations for lower rates imply investors see a weak economy ahead.
Is the yield curve inverted? Does that mean a recession's coming?
The two- to 10-year segment of the yield curve inverted briefly in late March for the first time since 2019 and again in June and the week starting July 4. . That doesn't guarantee a recession , but statistically, it seems very likely.
“Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve,” San Francisco Fed researchers said in a 2018 study. “Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession.”
How many times has an inverted yield curve predicted a recession?
An inverted yield curve, based on the difference between ten-year and one-year Treasury yields, has correctly signaled all nine recessions between January 1955 to February 2018, researchers said. There was only one false positive in the mid-1960s when an inversion was followed by an economic slump but not an official recession, they said.
How soon could a recession happen?
A simple rule of thumb given by San Francisco Fed researchers is a recession occurs within two years of an inverted yield curve. The time between the inverted yield curve and the beginning of a recession has ranged between 6 and 24 months, it said.
Statistically, the chances may be slim. As San Francisco Fed researchers showed in 2018, an inverted yield curve is "a strikingly accurate record for forecasting recessions."
Having said that, though, events of the last two years starting with COVID-19 in 2020 have been exceptional. For example, even as the economy has shown signs of a sharp slowdown recently, the labor market has proven extremely tight and resilient. June payrolls rose 372,000, topping the mean economist forecast for 250,000.
“The yield curve needs to remain inverted for several weeks before it would raise a red flag,” Ryan Sweet, an economist at Moody’s Analytics, wrote in a commentary on Tuesday, when the yield curve inverted.
Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at [email protected] and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday morning.