Inverted Yield Curve Suggesting Recession Around The Corner?

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The yield curve has inverted before every U.S. recession since 1975, although it sometimes happens months or years before the recession starts. Trefis in its dashboard Inverted Yield Curve: Is Recession Coming In Next 20 Months? analyzes how successful the inverted yield curve has been in predicting a recession and what is the likelihood of recession happening in the coming years. You can also find more Trefis Financial Services Data here 

What is Yield Curve, and when does it become ‘Inverted’?

  • The yield curve is a graph depicting yields on U.S. Treasury bonds at multiple maturities. Typically, it slopes upward, as short-term rates are lower than long-term rates as long-term investments attract additional risk premiums.
  • An inverted yield curve is a situation in which long-term rates are lower than short-term rates – suggesting that markets expect a recession, which will reduce interest rates in the near- to -mid-term.

As shown in the chart below (based on data from August 27, 2019), the yield curve was inverted as short-term interest rates (1 and 2 month maturity) were higher than the long-term rates (36-84 month maturity)

How successful has the difference between the 10-Year Treasury rate and 2-Year Treasury rate (T10Y2Y) been in predicting a recession?

  • The U.S. Federal Reserve’s preferred measure to gauge an inverted yield curve is the difference between the 10-year and 3-month treasury yields. To ensure that short-term fluctuations in interest rates are excluded, the Fed considers the yield curve to have inverted only when the difference in yields for these two securities remains negative for ten consecutive days.
  • However, we have used the difference between the 10-year and 2-year treasury securities as the base for our analyses.
  • The 10-year/2-year version of the yield curve has preceded each of the past five recessions, including the most recent slowdown between 2007 and 2009

Is the Inverted Yield Curve a consistent predictor of an imminent recession?

The inverted yield curve has consistently predicted a recession each of the 5 times in the last 5 decades

  • The inverted yield curve has been highly successful in predicting recession in the last 45 years.
  • An inversion has preceded a recession in the US economy each of the last 5 times.
  • Although, a recession follows the inversion but the timing is uncertain
  • In September 1980, the gap was just 10 months while in June 1998 it was 33 months.
  • Taking the historical average of time gap, a recession is very likely to follow in 20 months – which is around April 2021

Is there any relation between the difference of Treasury yields and time span of recession?

There doesn’t seem to be any discernible relation between these two parameters

  • The maximum difference between T10 and T2 yields during the lag was nearly 1.7% in Aug 1978 as well as Sep 1980. However, the recession that followed each of these yield curve inversions lasted 6 months and 16 months respectively.
  • Moreover, in 2006 the difference was just 20 basis points but the recession spanned over 18 months.
  • There, hence, seem to be no correlation between the difference of the yield and the time span of recession

For what proportion of the time gap has the yield curve been inverted historically?

  • The yield curve does not remain inverted during the entire time gap – it actually becomes normal just before the recession
  • Notably, the yield curve has been inverted for roughly 200 days during the gap before each of the last 4 recessions.
  • Because of this, the proportion was as high as 75% in the period after Sep 1980, just but was just 26% in the period after Jun 1998

How Did The S&P 500 Fare During the Time Gap?

  • During the time gap between inversion and recession, the performance of the S&P 500 has historically been robust
  • Moreover, during the 1988 gap, the index soared by more than 32% while during the most recent 2006 gap S&P 500 jumped by 16%.
  • In other words, the S&P 500 index generally peaks after an inversion before the economy slumps into recession.
  • On the flip-side, the S&P 500 gained during the first two recession cycles but the index lost more than 13% during 2001 recession and almost 35% during the 2008 crisis.
  • The fact that the S&P 500 index is at record highs currently, even as the yield curve remains inverted, only reinforces the historical trend of an upbeat equity market performance right before a recession.

Conclusion: Yield Curve Inversion Is An Important Recession Indicator

  • The yield curve is a key measure among many that could point to economic distress.
  • Going by historical data, the significance of an inverted yield curve in predicting recession cannot be ruled out.
  • Although, the time span has varied in each case, on an average it generally takes 20 months after the yield curve inverts for the U.S. economy to go into a recession.
  • Although, the economy is not showing any clear signs of an impending recession yet, we expect recessionary trends to grow more pronounced in the next 20 months.

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