Is the Yield Curve Signaling a Recession?

Long-term bonds generally provide higher yields than short-term bonds, because investors demand higher returns to compensate for the risk of lending money over a longer period. Occasionally, however, this relationship flips, and investors are willing to accept lower yields in return for the relative safety of longer-term bonds. This is called a yield curve inversion because a graph showing bond yields in relation to maturity is essentially turned upside down (see chart).

A yield curve could apply to any bonds that carry similar risk, but the most studied curve is for U.S. Treasury securities, and the most common focal point is the relationship between the two-year and 10-year Treasury notes. The two-year yield has been higher than the 10-year yield since July 2022, and beginning in late
November, the difference has been at levels not seen since 1981. The biggest separation in 2022 came on December 7, when the two-year was 4.26% and the 10-year was 3.42%, a difference of 0.84%. Other short-term Treasuries have also offered higher yields; the highest yields in early 2023 were for the six-month and one-year
Treasury bills.1 (Although Treasuries are often referred to as bonds, maturities up to one year are bills, while maturities of two to 10 years are notes. Only 20- and 30-year Treasuries are officially called bonds.)

Predicting Recessions

An inversion of the two-year and 10-year Treasury notes has preceded each recession over the past 50 years, reliably predicting a recession within the next one to two years.2 A 2018 Federal Reserve study suggested that an inversion of the three-month and 10-year Treasuries may be an even more reliable indicator, predicting a
recession within about 12 months.3 The three-month and 10-year Treasuries have been inverted since late October, and in December and early January the difference was often greater than the inversion of the two- and 10-year notes.4

Weakness or Inflation Control?

Yield curve inversions do not cause a recession; rather they indicate a shift in investor sentiment that may reflect underlying economic weakness. A normal yield curve suggests that investors believe the economy will continue to grow, and that interest rates are likely to rise with the growth. In this scenario, an investor typically would want a premium to tie up capital in long-term bonds and potentially miss out on other opportunities in the future. Conversely, an inversion suggests that investors see economic challenges that are likely to push interest rates down and typically would rather invest in longer-term bonds at today's yields. This increases demand for long -term bonds, driving prices up and yields down. (Bond prices and yields move in opposite directions; the more you pay for a bond that pays a given coupon interest rate, the lower the yield will be.)

Current Interest Rate and Inflation Situation

The situation is complex. The Federal Reserve has rapidly raised the benchmark federal funds rate to combat inflation:

• March 2022: near 0%
• December 2022: 4.25%–4.50%

The funds rate, which governs overnight loans between banks, directly affects other short-term rates. This explains why yields on short-term Treasuries have risen quickly.

The fact that 10-year Treasury yields have lagged behind short-term rates may indicate:

• Investors expect a recession, or
• Confidence that the Fed is controlling inflation and will lower rates in the coming years

The Fed projects:

• Funds rate peak: 5.0%–5.25% by the end of 2023
• Rates in 2024: 4.0%–4.25%
• Rates in 2025: 3.0%–3.25%

Inflation slowed somewhat in October and November 2022, but more progress is needed to reach the Fed’s 2% target.

The central question remains: Will controlling inflation require a recession, or can it be achieved without pushing the economy into reverse?

Other Indicators and Forecasts

Economists use many indicators to project economic trends. One of the most watched is the yield curve, but others include the 10 leading economic indicators published by the Conference Board. These indicators cover:

• Employment
• Interest rates
• Manufacturing
• Stock prices
• Housing
• Consumer sentiment

The Leading Economic Index, which aggregates all 10 indicators, fell for nine consecutive months through November 2022. Based on this data, Conference Board economists predicted a recession starting around late 2022 and lasting until mid-2023.

Recessions are officially declared by the National Bureau of Economic Research (NBER) only after they are underway. The Conference Board’s view suggests the U.S. may have already entered a recession.

In The Wall Street Journal’s October 2022 Economic Forecasting Survey, most economists expected the U.S. to enter a recession within 12 months, with an average duration of about eight months. More recent surveys, including those by the Securities Industry and Financial Markets Association (SIFMA) and Wolters Kluwer Blue Chip Economic Indicators, also projected a mild recession in 2023.

Currently, the economy remains relatively strong despite high inflation:

• November 2022 unemployment rate: 3.7%
• Estimated Q4 2022 real GDP growth: 3.8%

Indicators and surveys suggest that a near-term economic downturn is likely. This could result in job losses and temporary financial hardship, but a brief recession may help control inflation and stabilize the U.S. economy for future growth.

Important note on U.S. Treasury securities:

• Treasuries are guaranteed by the federal government for timely principal and interest payments.
• The principal value fluctuates with market conditions.
• If not held to maturity, Treasuries may be worth more or less than the original amount paid.

Forecasts are based on current conditions, may change, and may not come to pass.

Yield curve inversions do not cause a recession; they signal a shift in investor sentiment and may reflect underlying economic weakness.

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