Chart of the Week: Does a Yield-Curve Inversion Mean Recession Is Coming?

Jeffrey DeMaso

Portfolio Manager

The handwringing over a “yield-curve inversion” presaging recession has begun. Be prepared to hear a whole lot more about inversions in the weeks, months and quarters ahead.

First, a definition. The “yieldYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. curve” refers to a line on a chart mapping the yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. of Treasury bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. of various maturities. Most of the time, bonds with longer maturities yield more than bonds that will repay investors sooner, so the line curves upward, to the right. This makes sense: If a bank is going to lend you money for 10 years, it would probably ask for more in return than if it was lending you money for just three months or even two years. A yield-curve inversion occurs when that relationship flips and short-maturity bonds yield more than long-maturity bonds.

So why are pundits focused on inverted yield curves today? Historically, yield-curve inversions have forewarned of recession, with long lead times. Take a look at the chart.

We’ve plotted the difference (or “spread”) in yield between 10-year Treasury and 2-year Treasury bonds as well as the difference between 10-year and 3-month Treasurys—two common measures of the yield curve’s steepness. The gray bars mark recessions. As you can see, the lines have dipped below zero (sometimes barely)—meaning the yield curve inverted—before each of the past five recessions.

On Tuesday, the yield on 2-year Treasury bonds was briefly higher than that on 10-year Treasury bonds. They “inverted.” But not for long. That inverse relationship would have to last a lot longer than a few trading hours for it to count as a true harbinger of an economic slowdown.

More important, and hardly reported on, is this: As the 10-year to 2-year spread approached zero, the 10-year to 3-month spread moved in the opposite direction—nowhere near inverting. In the 40-year period charted, this is the most dramatic move in opposing directions these two measures have ever made.

We think you’d have to see both lines fall below zero to declare the yield curve truly “inverted.” But keep in mind: Even if we do see an inversion occur, it is not an immediate precursor to recession, but rather an early signal. Recessions have followed a year or two after the inversion, and timing the start and end of an economic slowdown is difficult, if not impossible. When forming a view of the economy’s prospects, our focus goes beyond the yield curve—and, in our view, this factor is barely flashing yellow right now.