EDITOR'S NOTE: The inverted yield curve. It’s one of the most historically consistent recession predictors. It doesn’t nail a recession every time, but it’s consistent enough to be considered a reliable indicator. Well, guess what...it’s flashing red once again. When a yield curve inverts, it means that short-term interest rates are higher than longer-term interest rates. Longer-term economic prospects are considered “poor” as fixed-income yields are expected to decline. Again, the predictive power of the yield curve is relative and open to interpretation. There’s certainly a correlation between inverted curves and recession, but correlation isn’t causation. Nobody knows for sure if or when the US economy will enter a recessionary phase. Still, many investors may feel compelled to hedge against the likelihood of one materializing. What’s your position on this matter, and what, if at all, are you doing to hedge against this phase of the economic cycle?
Yield gap on 2-year and 10-year Treasuries
One of the best-known recession indicators is flashing warning signs on the economy. Yields on longer-term U.S. government bonds are in danger of slipping below yields on short-term bonds, a relatively rare occurrence known as an "inversion."
Why it matters: Inverted yield curves can reflect a rising risk of economic recession. Analysts and investors closely watch for this early warning sign.
How it works: When the economy is healthy, yields — the interest rates investors are paid for buying government bonds — should be higher on longer-term bonds.
The intrigue: This year, short-term Treasury yields — which tend to be driven by expectations for the Federal Reserve's monetary policy moves — have shot higher, to 2.2% from about 0.75%.
- This reflects the Fed's move to choke off inflation by raising rates.
Meanwhile, yields on longer-term Treasuries — which tend to be more sensitive to the outlook for economic growth and inflation — have risen too, but a lot more slowly (to 2.4% from 1.5%).
- This reflects, in part, expectations that the war in Ukraine will hurt the world economy.
What's happening: The yield on the 10-year note is now only about a quarter percentage point higher than the two-year note, with many analysts expecting to see the 10-year fall below the two-year — an inversion! — sometime soon.
What they're saying: "If this continues, the risk is for an inverted yield curve," wrote Bank of America analysts in a note last week. "2s-10s inversions have preceded the last eight recessions and 10 out of the last 13 recessions."
Yes, but: Whether a recession follows could depend on whether the Fed continues to constrain the economy with rate hikes if and when an inversion occurs.
Flashback: When the yield curve began to approach inversion in 2018, it set off alarm bells about recession and helped trigger a near 20% drop in the stock market, as well as loud complaints from then-President Trump about the Fed's rate-hiking plans.
- In early January 2019, the central bank backed off the hiking plans and instead started chopping rates.
- The economy remained strong, and for a while, it seemed like the curse of the inverted yield curve had been broken.
The punchline: Then COVID arrived, and the U.S. suffered one of its most severe economic downturns on record. The predictive power of the yield curve lives on.
Go deeper: Fed's Powell bets on a buoyant economy
Originally published on Axios.