Inverted Yield Curve: Recession Coming?

A combined measure of 10-year government bond yields from a basket of major economies has fallen below a similar basket of 1-3 year government bonds—in other words, you can get a (slightly) higher coupon payment if you go short than if you make a longer-term bond investment. (See chart.) That, of course, is the definition of an ‘inverted’ yield curve, which is one possible signal that a recession is approaching.

As you can see from the chart, the inversion is pretty mild at this point, but the trend is clear over the past 12 months. Investors tend to switch their attention to longer term bonds when they’re pessimistic over the outlook for the economy, and today they might believe the central banks are choosing to fight inflation vs. encouraging economic growth. Here in the U.S., the spread between two-year and 10-year Treasury yields recently hit its highest inversion level since 1981-82.

Of course, the collective wisdom of investors is not always right about these things. One analyst noted that the U.S. disparity between higher (4.37%) 2-year Treasury rates and lower (3.7%) 10-year rates might simply mean that investors think the U.S. Fed is going to keep raising interest rates (high short-term rates) and successfully tame inflation (meaning that the 10-year rate would offer positive after-inflation returns over time). But it’s worth noting that the last time we saw an inversion of this magnitude, during the Reagan Administration, the U.S. was in the midst of one of the worst economic downturns since the Great Depression. It’s definitely something to keep an eye on.

Sources:

https://www.bloomberg.com/news/articles/2022-11-29/global-yield-curve-inverts-in-signal-a-recession-is-brewing

https://www.marketwatch.com/story/most-deeply-negative-treasury-curve-in-more-than-four-decades-has-one-upbeat-takeaway-for-investors-11669750894