The inverted yield curve: Still a reliable signal?

Senior Investment Strategist Tracey Manzi notes that while the predictive power of the inverted yield curve has waned this cycle, investors shouldn't dismiss the warning signs entirely.

To read the full article, see the Investment Strategy Quarterly publication linked below. 

For decades, yield curve inversions have been a closely watched indicator by financial professionals and the media. And there is good reason for that, as inverted yield curves (i.e., when shorter-maturity yields are above longer-maturity yields) have historically served as an early warning sign of an impending recession. In fact, the 2-year to 10-year yield curve has correctly predicted the last six recessions, only giving one false signal in 1998 – with a recession typically following 14 months, on average, after the curve first inverts. However, this economic cycle has seen many reliable indicators provide false signals, with the inverted yield curve among them. Below we explore whether the yield curve is providing a false signal this time around and what, if any, implications this may have for investors going forward.

What does the shape of the yield curve signal?

Let’s take a step back and look at what signal the yield curve is sending to the market. While there are countless yield curve segments to monitor, the most widely quoted yield curve in the financial media is the 2-year to 10-year spread. Under normal circumstances, the shape of the yield curve is positively sloped, meaning that short-term interest rates are lower than long-term interest rates. Positively sloped yield curves signal that the market expects economic growth to expand in the future, with yields on longer-term maturities higher than yields on short-term maturities as investors demand extra compensation for inflation and the potential for future rate increases. Conversely, inverted yield curves signal that economic growth is expected to slow and that interest rates will be lower in the future. Hence, the yield curve captures the market’s expectations for growth, inflation and the direction of monetary policy going forward.

Inverted yield curves also tell you that the Federal Reserve’s (Fed's) monetary policy stance is restrictive, as policymakers (who control the front end of the yield curve) are actively seeking to restrain growth and dampen inflation pressures. More important, history has also shown that when the 2-year to 10-year yield curve shifts from its peak inversion point to a positively sloped curve, that has traditionally been one of the strongest signals that a recession is approaching. In fact, a recession has typically followed within two to six months of the curve slope turning positive again. That is why investors are so interested in what comes next, and how best to position their portfolios.

Why this time may be different

While the market has been on recession watch for well over two years now, starting just after the U.S. economy recorded two consecutive quarters of negative GDP growth in 2022 and again following the first inversion of the yield curve later that year, there is little on the horizon that suggests the economy is at risk of tipping into a recession any time soon. Yes, the economy is slowing, and our economist still expects a modest slowdown in the coming quarters; but barring an exogenous shock, a soft landing remains the most probable outcome. There are several reasons:

• The economy has been remarkably resilient in the wake of the Fed’s most aggressive tightening cycle in forty years. Up until now, weakness in some sectors of the economy (i.e., interest- rate sensitive sectors, such as housing and manufacturing) has largely been offset by strength in other areas. The initial boost of spending on things like travel following the reopening of the economy after the pandemic turbo-charged the recovery. Several rounds of fiscal stimulus in the form of the CHIPS, IRA and Infrastructure Act passed by Congress over the last few years have also boosted growth. Sure, these areas of support could fade, but the point is: the Fed has plenty of fire power at its disposal to lengthen the expansion’s runway and fend off any recession risks that arise.

• While the labor market is cooling, the unemployment rate (at 4.2%) remains low by historical standards even though it has climbed 0.8% since 2023. Thus far, much of the adjustment has come from a slowdown in the pace of hiring, with job growth averaging 114k over the last three months, down from a 196k pace over the last 12 months. The key point: the slowdown in the labor market from its overheated pace has occurred with minimal job losses. And if our economist is right, we should not see any job losses this cycle – that’s a big difference versus other cycles.

• Finally, the Fed did not overtighten. While there is some truth to the old adage that “The Fed will keep raising rates until something breaks” – it has done an exceptional job navigating one of the most challenging economic cycles in modern history. For sure, there have been some growth scares along the way, and we are not fully out of the woods yet – but so far, the Fed’s campaign to slow the economy and rein in inflation has done so without plunging the U.S. into a recession.

While the predictive power of the inverted yield curve has waned in this cycle, it does not mean that investors should dismiss the warning signs entirely. That is why we continue to monitor it; but augment our analysis with other fundamental macro signals. And for now, these signals suggest the U.S. economy is on track for a soft landing.

   
Read the full
Investment Strategy Quarterly

Read the full
Investment Strategy Quarterly

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