The Inverted Yield Curve Isn't as Predictive as You Think
An inverted yield curve is one of those trends that forms right before a recession and many view it as one of the most reliable predictors of an impending downturn. It has predicted nearly every recession dating back to the 1950’s, but not this time.
While an inverted yield curve is typically a result of investor fears of recession, the most recent inversion was due to the expectation that the Federal Reserve (Fed) would not maintain a higher for longer interest rate environment. It’s different this time.
A recent Barron’s article aptly describes the situation: “At the most basic level, an inverted yield curve simply means that bond investors expect interest rates to be higher in the short-term of two years than over the longer-term of 10 years.” But why? Has the yield curve inverted because of fears of recession or has the yield curve inverted for the more fundamental reason that rates are likely to come back down irrespective of recession fears? I believe it’s the latter.
An inverted yield curve occurs when a 2-year Treasury Bond has a higher yield than a 10-year Treasury. A normal yield curve slopes upward because investors typically demand more yield for the patience of waiting longer for a bond to mature.
When the yield curve inverts due to fears of recession, investors reposition into safer assets. They opt for bonds with longer maturities to lock in steady income for longer stretches of time instead choosing short-term bonds. Because the demand for high quality 10-year bonds rises versus short-term bonds, the yield curve inverts. This has historically been a reliable harbinger of the sun setting on the economy.
This may seem obvious, but there is an underlying implicit assumption of cause and effect. It’s like a syllogism: If the yield curve inverts, then a recession will occur. This is a logical fallacy. Of course, no one believes that an inverted yield curve is the cause of recession if they stop and think about it, but many implicitly assume that inversion necessarily leads to recession. This is not the case.
Think about it: much of the news we consume about the yield curve is inherently negative. But many, if not most, analysts fail to contextualize the broader drivers behind yield curve inversion. There are three problems.
First: If we are going to settle on the assertion that inversion is a good predictor of recession, then we must assume that the yield curve only inverts due to investor fears of recession. But that is not true.
Regarding the current cycle, the yield curve was inverted from July of 2022 until just recently. It is no longer inverted and is flat as of September 6. It should be noted that this type of reversal often occurs just before a recession sets in.
But this most recent inversion and subsequent reversal wasn’t due to recession fears. This trend occurred because the Fed aggressively raised short-term rates to combat inflation, yet investors were not convinced this would be a longer-term policy course. The longer-end of the curve — which is more heavily influenced by the market forces of supply and demand — remained low because investors assumed that rates would not remain elevated for the long-term. Furthermore, the Fed has been broadcasting for a nearly a year now that they plan on lowering rates which has played a clear role in anchoring expectations for the long end of the curve — i.e. lower 10-year Treasury yields. Although expectations of Fed rate cuts were early, and that the Fed has been delayed in their plans, investors have been validated.
The point is not whether investor expectations were right or wrong or even timely, the point is that they indeed had expectations. The driver of yield curve inversion was that they anticipated rates coming down, not necessarily that a recession was setting in. If they were predicting the Fed was going to cut rates rapidly in response to a recession, this would be an entirely different story.
Second: inversion can be a false signal. According to economic research from BNP Paribas, the yield curve aggressively flattened and nearly inverted in 1994 after the Fed started raising rates, but a recession did not occur. The Cleveland Fed also wrote: “There have been two notable false positives: an inversion in late 1966 and a very flat curve in late 1998.”
Third: Because recessions occur with some degree of regularity, yield curve inversion sometimes coincides with recession. This correlation can be mere happenstance. For instance, the yield curve inverted in August of 2018 due to recession fears from Fed tightening and trade wars with China. The inversion accurately predicted recession in early 2020, but the recession occurred because of Covid-19 lockdowns, not Fed policy and tariffs. The yield curve inversion in 2018 would likely have been a false signal as the economy was strong in 2019.
Furthermore, why look at investor expectations when you can look at economic data? If the curve inverts because there are serious warning signs of recession, such as soaring home foreclosures from 2005 to 2008, then it is a secondary signal of problems ahead, and thus may be redundant. The housing bubble caused the Financial Crisis, not an inverted yield curve. Obviously.
There are plenty of leading economic indicators that are better at suggesting where the economy is headed such as industrial production, employment data, the Purchasing Managers Index, and others. Employment data for instance, although softening, remains resilient. These indicators more or less speak for themselves while an inverted yield curve requires greater contextualization. The inverted yield curve is merely a measure of investor expectations on the future interest rate environment. Why rely on investor expectations when we have hard data?
If we view the yield curve as a harbinger of recession, then all it really tells us is how investors feel about the economy. It is clearly more dynamic than that. Also, investor sentiment remains somewhat bullish according to the AAII Investor Sentiment Survey from September 4 with only 24.9% of surveyed respondents having a bearish outlook and 45.3% having a bullish one.
If the yield is merely a reflection of recession fears, then investor sentiments should also be bearish. In this case it is not, and we are left with the explanation that it is a reflection of anticipated Fed rate cuts.
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