Inverted Yield Curve
And the looming recession
With the recent downturn in the stock market, it seems to be the end of an epic bull-run in the US. Fueled by interest rate cuts, stimulus paychecks, minimal discretionary spending, and reduced transportation costs - the stock market saw an increase of ~90% (in DOW) and ~100% (in S&P500) from March 2020 to December 2021.
However, from Dec 2021 to June 2022 - the market has dropped by 14% (in DOW) and 23% (in S&P500). Does this mean the US is entering a recession, and more importantly could we have seen this coming?
I learned there is an indicator that has been hailed to do exactly this - the inverted yield curve.
Before we talk about its accuracy, let’s break down this indicator and see how it is related to recession.
Yield Curve - it is the relationship between expected return and time. More specifically, we are talking about high credit quality debt like the US treasury bond. When you buy these bonds, you can specify how long until you receive the repayment for buying them and that is known as its “term to maturity”. Usually, the longer the term to maturity is, the higher the yield. So a typical yield curve for such debt is as follows:
Inverted - in this hypothetical yield curve, the long-term yield is higher than the short-term yield because stocks only go up (/s). Inversion happens when the yield on a long-term bond is less than that of a short-term bond. This is also known as the “interest rate spread”.
2/10 and 3mo/10 - The common spread to use as the indicator is between the 10-year bond and 2-year bond (2/10) and the 10-year and 3-months bond (3mo/10).
With this knowledge, we can dissect articles such as this one published by the Federal Reserve Bank of San Francisco. The captivating quote that caught my attention was:
Every US recession in the past 60 years was preceded by an inverted yield curve, furthermore, a negative yield term curve was always followed by an economic slowdown and except for one time, by a recession.
But digging deeper, we see that the lag between the last 6 recessions and the inverted yield curve ranges from 6 to 24 months. Also, the length of the recession is not predictable by the magnitude of the inversion.
If you take a look at the 2/10 spread on FRED from 1976 you can see that large inversions are not followed by long recessions and the lag is quite sporadic. The same can be said for the 3mo/10 spread.
Takeaway
The yield curve is essentially an average outlook of the economy and inversion occurs when market is pessimistic and it is a good indicator to mark this pessimism. This usually signals a recession because the average outlook is the wisdom of the crowd - an eerie phenomenon that shows the collective opinion about something is quite accurate.