Market watchers broke into a collective sweat recently when the yield on 10-year Treasuries sank below the 3-month T-bill yield. When yields on short-term debt exceed those on longer-term bonds, the yield curve—a representation of interest rates on bonds of varying maturities—is said to be inverted. A little perspiration is understandable: An inverted yield curve has preceded each of the past seven recessions, dating back to the mid 1960s.
An inversion is considered a recession indicator because although short-term rates are driven by current Federal Reserve policy, longer-term rates reflect bond investors’ expectations for inflation and future economic growth. When investors believe that the economy will weaken, they tend to pile into the safe haven of longer-term Treasuries, locking in higher rates while they can. In doing so, they bid up the price of long-maturity bonds, driving down yields (bond prices and yields move in opposite directions). A yield curve inversion is an extreme, and rare, no-confidence vote.
As with any economic bellwether, the yield curve isn’t foolproof. Although all recessions since the ’60s have followed inversions, not all inversions have led to recessions. And there is little predictability as to when a recession will hit or how long it will last. Since 1968, the time between the inversion and eventual recession has ranged from five to 16 months.
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Moreover, March’s inversion wasn’t severe (a difference of only a few hundredths of a percentage point) or long-lasting (it has since flipped back). Should the long end dip more than 0.5 percentage point below the short end, it would be cause for greater concern, says LPL senior market strategist Ryan Detrick.
Whether the recent inversion is a blip or a harbinger of recession remains to be seen. Regardless, investors should consider it a sign that things are closer to the end than the beginning of the economic cycle, says Sam Stovall, chief investment strategist at research firm CFRA. “By July, it will have been the longest economic expansion in history. Things don’t last forever, right?” he says.
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