The Yield Curve Is Flattening, but Has Yet to Signal a Recession

The yield curve made headlines on Tuesday when it briefly inverted. The 10-year Treasury note’s yield dipped below the two-year note’s yield at 2.39% on an intraday basis. The 10-year note ended the day with a yield that was six basis points higher than the two-year note’s yield (2.41% versus 2.35%).

Inverted yield curves occur when bonds with shorter maturities trade at yields that are higher than those for bonds with longer maturities. Traders are willing to accept lower relative yields on longer-maturity bonds if they think interest rates will fall in the future because of weaker economic conditions.

This is why inverted yield curves have a reputation for being harbingers of recessions. Prior to the 2020 recession, the average length of time between an inversion occurring and a recession starting was 11 months. There is much variance around this number, however. A 2018 Federal Reserve study found that the lead time between a yield curve inverting and a recession starting ranged from six to 24 months.

How yield curve inversion is measured matters. Duke professor Campbell Harvey, who first documented inverted yield curves as a recession indicator, contrasted the yield on the three-month Treasury bill with the yield on the five-year and 10-year notes. He told us in a 2019 interview that he looks “for the average of the yield curve slope over the quarter to be negative.” On this basis, the yield curve has yet to signal that a recession is occurring despite all the attention paid to it on Tuesday.

The yield curve is flattening though, as you can plainly see. I included the yield curve from February 2021 to provide some contrast. The yield curve was steepening then as bond traders were expecting economic growth to occur when the first coronavirus vaccines were given.

Now, we have second booster shots being suggested for certain populations, high oil prices and the Federal Reserve attempting to do a “soft landing.” High energy costs have preceded many of the past recessions. A report recently published by investment bank Piper Sandler argued that the Fed has accomplished “only one true soft landing versus eight recessions” during the past 60 years. (The record improves to 1-7 if the coronavirus recession is excluded.)

An ongoing challenge for Fed chair Jerome Powell and the rest of the Federal Open Market Committee (FOMC) is inflation. It hasn’t been as transitory as they previously hoped. Some of this is due to ongoing supply chain issues. (Even the cost of printing the AAII Journal is being driven up by supply chain issues.) Part of it, however, is due to expectations. It doesn’t take any knowledge of economics to understand which direction prices have been moving in. Breakeven rates, shown in the second chart, signal what traders expect the rate of inflation to be over the next five and 10 years.

None of this guarantees that a recession is coming. The Atlanta Fed’s GDPNow estimates first-quarter economic growth to be 1.3%. Not high, but still positive. An easing of supply chain issues—which is expected to occur this year—combined with more oil production would help to ease inflationary pressures. FOMC members, who are aware of the historical record, may avoid overshooting on rate hikes.

To the extent that the financial markets are efficient, prices and yields should reflect prevailing expectations about where the economy is headed. We’re seeing uncertainty being priced in by the bond market via yield curves as well as by the major stock indexes, which remain below their record highs. Spot prices in the commodity markets remain high because of demand and not enough supply (including the impact of Russia being rightfully sanctioned).

Is the market sometimes wrong? Absolutely. But then you must have the foresight to know in what way, by how much and by what amount of time. Many people have forfeited a large amount of wealth by being overconfident in their ability to predict what is going to happen. This is why we encourage individual investors to invest with a long-term view while, at the same time, ensuring that your allocation also accounts for any shorter-term withdrawals that may be needed.