Warning Signal: Curve Inversions & Recessions — Since 1955 every US recession has been preceded by a protracted yield curve inversion with only one significant false signal.
Few economic indicators are followed more closely than the yield spread between the 2-year and the 10-year US Treasury notes, and for good reason. A negative yield curve had preceded every recession since 1955, with only one false signal during the mid-1960s when growth slowed but did not tip to recession.
Investors took notice when the 2Y/10Y spread inverted briefly last week, contracting to its lowest point since the initial lockdown announcements in early 2020. This followed an inversion of 5-year and 30-year Treasury yields earlier in March, marking the first inversion for that measure since 2006. Traditionally, an inverted yield curve is viewed as a harbinger of recession because investors are willing to accept limited yield for longer-dated bonds, suggesting slower growth ahead.
According to some experts, the predictive value of a negative yield curve taken on its own is debatable. In a research note released on March 31, Goldman Sachs strategist Vickie Chang argues the evidence for the accuracy of this singular indicator as a bellwether is inconsistent.
According to Chang’s analysis, yield curves predict recessions better than other market indicators, although there is variation across time horizons and specific curves. Meanwhile, equity returns, volatility, and credit spreads appear to do a poor job as long-term predictors but are better at identifying imminent recessions — typically within the next two quarters.
“In other words, different assets embed different information,” notes Chang. “Yield curves by nature show expected rate paths over time, and so incorporate information about investors’ expectations about the path of the policy rate across a broader range of horizons. As a result, they are better overall recession indicators.”
Thus, despite the warning signal of the recent inverted yield curve, most economists and strategists give low odds of a looming recession. Inflation expectations, rather than concerns about growth, could be driving higher prices for shorter-term bonds, making the case for recession weaker. To date, spiking commodity prices have not sparked fears that inflationary pressure is here to stay.
The 5-year inflation expectation calculated by comparing the yields on Treasury inflation-protected securities with that of Treasury notes is currently 3.42% — elevated well above recent historical averages but less than half of the most recent US Consumer Price Inflation reading of 7.9% for February. Clearly, markets continue to anticipate that price pressure will moderate in the coming 12 to 24 months.
While the inflation argument for the current shape of the Treasury curve weakens the case for a recession in the foreseeable future, it does not eliminate it. According to Goldman’s Chang, “The market is currently pricing recession probabilities that are broadly consistent with the shape of the curve — close to no chance of a recession in the next 12 months, but a higher risk of recession [38%] in the following year.”
The US Treasury yield curve inverted last week as the market price of longer-dated securities registered higher than those for shorter horizons.
Traditionally, this phenomenon has been interpreted as a US recession indicator and has preceded every growth contraction since 1955.
While this indicator continues to present a warning signal, the consensus among economists is that a recession remains unlikely.