An inverted yield curve has a strong record as a recession predictor
The yield curve has captured Wall Street—and to a lesser extent Main Street’s—attention in recent weeks. And for a good reason. The past nine recessions have been preceded by the inversion of the curve, where short-term Treasury rates exceed their long-term counterparts.
Much of the breathless attention on the shape of the curve has centered on the tightening gap between the 2-year and 10-year Treasury yields. But there are other key pairs that can signal how investors are thinking about where the economy is headed from here.
While 2s-versus-10s garners the most attention, many economists and Fed officials tend to focus more acutely on the gap between the 3-month bill and the 10-year note as the best signal, if it inverts, of an impending recession. This relationship, which grasps the more dramatic difference between very near-term rates and a reasonable point of time in the uncertain future, has a better track record, these researchers say.
The probability of a recession over 12 months gradually climbed to 40% in 2008 from less than 10% when the 3-month-10-year spread inverted substantially in June 2006, according to data from the New York Federal Reserve.
The gap between these Treasury pairs tends to be viewed as a good read of inflation expectations and economic strength. A weaker economy and flagging inflation expectations, which chip away at a bond’s fixed value, can result in a tighter yield spread, said Jim Smiegel, chief investment officer of absolute return strategies for SEI Investments.
A canary in the coal mine, an inversion between the 7-year and the 10-year notes implies that other parts of the curve may soon invert, according to Ian Lyngen of BMO Capital Markets. He found that when the yield gap between the two maturities fell below zero in 1988, other pairs also soon inverted.
The gap between the 10-year note and the 30-year bond isn’t widely watched by professionals but it is another fault line in the yield-curve dynamic that could presage ill for the market, as it has reached its tightest since 2007.
This remains the most popular way to assess the yield curve’s slope on Wall Street. Because investors normally demand a higher return for borrowing long term than on a shorter-term basis, the slope is positive (upward sloping left to right) during an expansion, with long-term interest rates typically running a couple percentage points above short-term rates. That means an inverted curve in the 2s and 10s tends to reflect a dimming outlook for the economy. Its tightening trend has been hastened by a Federal Reserve bent on raising short-term rates.