Question

Define inverted yield curve and why it may indicate that a recession may be looming. In your opinion, is the US economy at the risk of a recession in the near term, and why or why not?

Answer 1

What Is an Inverted Yield Curve?

An inverted yield curve represents a situation in which long-term debt instruments have lower yields than short-term debt instruments of the same credit quality. An inverted yield curve is sometimes referred to as a negative yield curve.

When the yield curve inverts, short-term interest rates become higher than long-term rates. This type of yield curve is the rarest of the three main curve types and is considered to be a predictor of economic recession. Because of the rarity of yield curve inversions, they typically draw attention from all parts of the financial world.

A true yield curve compares the rates on most or all maturities of a given type of instrument, presented as a range of numbers or a line graph. For example, the U.S. Treasury publishes a yield curve for its bills and bonds daily. For ease of interpretation, economists frequently use a simple spread between two yields to summarize a yield curve. The downside of using a simple spread is that it may only indicate a partial inversion between those two yields, as opposed to the shape of the overall yield curve. A partial inversion occurs when only some short-term bonds have higher yields than some long-term bonds.

One of the most popular methods of measuring the yield curve is to use the spread between the yields of ten-year Treasuries and two-year Treasuries to determine if the yield curve is inverted. The Federal Reserve maintains a chart of this spread, and it is updated on most business days and is one of their most popularly downloaded data series.

The ten-year/two-year Treasury spread is one of the most reliable leading indicators of a recession within the following year. For as long as the Fed has published this data back to 1976, it has accurately predicted every declared recession in the U.S., and not given a single false positive signal. In August of 2019, the spread dipped below zero, indicating an inverted yield curve and giving a hard signal of an economic recession in the U.S. in 2020.

Historical Examples of Inverted Yield Curves

• In 2019, the yield curve briefly inverted. Signals of inflationary pressure from a tight labor market and a series of interest rate hikes by the Federal Reserve from 2017 to 2019 raised expectations of a recession. Those expectations eventually led the Fed to walk back the interest rate increases. This inversion of the yield curve signaled the onset of recession during 2020.
• In 2006, the yield curve was inverted during much of the year. Long-term Treasury bonds went on to outperform stocks during 2007. In 2008, long-term Treasuries soared as the stock market crashed. In this case, the Great Recession arrived and turned out to be worse than expected.
• In 1998, the yield curve briefly inverted. For a few weeks, Treasury bond prices surged after the Russian debt default. Quick interest rate cuts by the Federal Reserve helped to prevent a recession in the United States. However, the Fed's actions may have contributed to the subsequent dotcom bubble.