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Why the inverted yield curve is typically a recession predictor

Stacey Vanek Smith Sep 12, 2024
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The yield curve in the U.S. Treasury market has been singing a scary tune for nearly two years. So where's the recession? Torsten Asmus/Getty Images

Why the inverted yield curve is typically a recession predictor

Stacey Vanek Smith Sep 12, 2024
Heard on:
The yield curve in the U.S. Treasury market has been singing a scary tune for nearly two years. So where's the recession? Torsten Asmus/Getty Images
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There are a lot of recession predictors people watch: Some track imports, some track wholesale prices, some even track light truck sales and Statue of Liberty visits. But one of the most watched recession predictors comes from an entirely different part of the economy: The market for U.S. Treasury bonds. That market is big — worth about $27 trillion. It’s also been flashing red for more than a year because of its “inverted yield curve.”

The yield curve was identified as a recession predictor in the 1980s by Duke University economist Campbell Harvey. Though it can feel confusing and technical, Harvey said, at its heart, the yield curve is really very simple.

“The theory behind this indicator is very straightforward,” he said. “Econ 101.”

1. The Yield

To explain the yield curve, let’s start by breaking down the term itself. So what is the “yield” part of “yield curve”?

By yield, we mean “bond yields.” Bonds are loans you make to companies or governments, but in this case we’re concerned with loans to the federal government. These loans have different durations, among them four weeks, three months, five years, 10 years (I’m looking at you, 10 year T-note!) 

And when the time comes, the government pays you back for that loan plus interest. That interest is called the yield, calculated on an annual basis, and it varies depending on the term of the bond.

Harvey said it works exactly the same as any loan at a bank. “We walk into a bank and we see a certificate of deposit where I locked my money in for five years,” he explained. “That’s got a higher rate than if I put it in for 90 days.” That’s because, if the bank has your money tied up for five years (as opposed to 90 days) they need to pay you a premium. “Now, that’s the usual situation,” said Harvey. 

It’s the basic laws of FOMO: When an economy is cooking, investors want to have cash on hand to buy Nvidia stock, for instance, or splurge on a Tesla Cybertruck. The government has to pay a higher interest rate for those 10 years of lost opportunities. 

2. The Curve

So that’s the yield part. Next up, the curve. 

If you lay out government bonds in order of duration: four weeks, three months, one year, five years, 10 years, and plot out their interest rates (or yields), in a healthy economy you should see a curve. Shorter-term loans should have a smaller payout, while longer-term loans have a larger payout. Here’s an example of a yield curve in a healthy economy:

If you converted those interest rates into musical notes, the yield curve should sound something like this (courtesy of my editor, Amanda Peacher, and her cello)

Lately, though, the yield curve has been singing a different tune. “Short-term rates are higher than long-term rates,” noted economist Campbell Harvey. “So something must be going wrong.”

Honestly, it seems wrong. Right now the government is paying people a higher interest rate to borrow their money for four weeks than for 10 years, which is weird, right? Shouldn’t the government have to pay you more for the 10 years of no Tesla truck? What is going on? 

“When there’s economic uncertainty, people go into the safest asset in the world, and that’s the 10-year U.S. Treasury bond,” Harvey explained.

In other words, when the economy seems dicey, people stop caring about FOMO and start caring about safety. They want to stash their money somewhere and not worry about it for a long time. And, because demand is high, the government does not have to pay as much interest to investors for those longer-term bonds. 

Here’s what Thursday’s yield curve looked like:

And here is what it sounded like:

That’s the song of an inverted yield curve, and it is often considered a bad economic omen. But the yield curve has been singing this scary tune for 20 months. So where’s the recession?

“The yield curve is a leading indicator,” said Harvey. A leading indicator is an indicator that tends to imply future conditions, for instance a dismal economic statistic that might show up before a recession starts. In the case of the yield curve, it has typically inverted between six months and two years before a recession begins.

So, does Harvey think a recession is about to happen? “I think we’re on the edge of a slowdown that could lead to a recession in the fourth quarter of 2024, the first quarter of 2025.” However, this prediction has a silver lining. “There’s reasons to believe that a recession would be a ‘soft landing’ recession.”

Soft landing recession, meaning a few months of mild slowdown followed by a pretty fast recovery. And the reason for the mildness of this potential recession? The recession indicators themselves have given companies a chance to prepare, Harvey said.

“If there’s a recession, this would be the most anticipated recession,” he said. “We’ve actually seen companies taking actions.”

Actions like slowing down expansion plans or even doing what Harvey calls preventive layoffs: slimming down staff, cutting unprofitable departments. 

“You might think, ‘Well, is that a bad thing?'” Harvey said. “I don’t think so. Think of the alternative: We go into a recession and then these companies need to slash. So instead of this 10%, they slash 40% because they’re struggling for survival, and many don’t survive, like we saw in the global financial crisis [of 2007-08]. This is the trade-off.”

In other words, the song the yield curve has been singing for the last 20 months has slowed the economy down, but it’s also possibly saved us from a more severe recession.

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