The Inverted Yield Curve Guide to Recession

The U.S. economy seems to be doing fine. Growth, for the most part has been trending upwards, albeit slowly; the job market continues to shine; and inflation is becoming less of a worry for the Federal Reserve. However, one indicator is suggesting that everything is not as rosy as it seems, and a recession could be around the corner. 

The yield curve is the spread between short-term and long-term bond yields (interest rates). A normal yield curve is where short-term rates are lower than long-term rates, and investors believe the economy is expanding. An inverted yield curve is where short-term rates are higher than long-term rates. It's a bad sign because it shows investors want to secure their money for the short term and seek long-term returns. Most analysts look at the 2s10s: the spread between the 2-year yield and the 10-year yield. (For more see: Understanding The Treasury Yield Curve Rates.)

Inverted Yield Curve as Recession Predictor

An inverted yield curve has predicted the last seven recessions dating back to the 1960's. The most recent was in 2006 when Alan Greenspan and the Federal Reserve increased the Fed funds rate 400 basis points and the 10-year yield rose less than 50 basis points. Economists at the time dismissed this, saying "this time it's different," and the economy is in better shape. "I don't get the sense that there is any panic because firms have learned a lot since 2000 about being prudent," an analyst at Celent said in 2005. Oh, how they were wrong. 

Source: FRED database

There's an argument that things are worse today than they were in 2006. Leading into 2006, GDP in the U.S. was robust, holding above 3 percent from 2003 to 2006, while today the latest GDP report showed the U.S. economy grew at a benign 1.6 percent, and political instability in Washington D.C. has given the Trump trade a dose of reality. 

In December, a month after Trump was elected, his fiscal stimulus and pro-business policies saw growth expectations rise, and the 2s10s spread reached 1.33 percent. However, as sentiment has waned this spread has fallen back to December levels. Even after a hawkish Fed statement in June, the curve continued to flatten, pushing the spread to 0.83, just 7 basis points from the 2016 low, which is the lowest level since November 2007, months before the Great Recession.

So what could stop the yield curve from inverting? The first answer is simple; the economy picks up, growth goes back towards 3 percent, and inflation holds above the Fed's 2 percent target rate. Everyone is happy. If this doesn't happen, the Fed does have something on its side: a seemingly unlimited balance sheet. There is a case that if the economy does fall back into a recession the Fed could start up the printing press and head back to an aggressive easing policy, something that seemed highly unlikely a few years ago. But maybe this time around it will be different, and 2006 was an anomaly – as was 2000, and 1989, and so on. (For related reading, see "Time to Worry About Yield Curve Inversions?")

Whatever the case, the inverted yield curve is starting the conversation no one wants to have. Is there a recession around the corner?