Waiting for Reversion
#59: Rethinking the Yield Curve Recession Indicator
Understanding the yield curve can provide critical insights into economic cycles. Over the last 40 years, the curve has served as one of the most reliable predictor of recessions. But is this still the case? Let’s explore.
The Curve and the Cycle
Typically, we expect long-term interest rates to be higher than short-term rates. By lending at a fixed interest rate for an extended period of time, a lender is exposed to changes in interest rates that effect the market value of the loan or bond - interest rate risk1, or term premium. Plus, the longer the borrower holds the money, the more opportunity there is for something to go wrong - credit risk. Finally, lenders demand a premium for locking up money for an extended period of time - liquidity preference.
The general business of lending is predicated on this notion, which allows banks or other lenders to “borrow short and lend long”, capturing the spread between the two rates2. But when short-term rates rise while long-term rates remain fixed, there is less incentive to lend, slowing credit creation and economic activity. Therefore, these interest rate dynamics have strong correlations to the credit and economic cycle.
The U.S. Treasury yield curve, which serves as the benchmark for all other debt securities, is derived from the market yield of Treasury Securities (USTs) ranging in duration from one month to thirty years. The most commonly cited yield curve spreads are calculated by taking the yield of 10-year USTs and subtracting either the 2-year UST yield (“10y2ys”) or the 3-month UST yield (“10y3ms”).
When these spreads are positive, the yield curve is considered “normally” shaped and lending is profitable. When these spread are negative, the curve is considered “inverted” and lending becomes more challenging. As shown below, an inversion of the yield curve has preceded every recession since 1990. Importantly, this inversion is a leading indicator.
The evolution of the yield curve during the last four economic cycles has followed a consistent pattern.
The curve is at its widest point during the early stage of the growth cycle, as the central bank lowers short term rates to incentivize lending. Then, the curve compresses throughout the cycle as the central bank raises rates to slow the pace of growth and keep the economy from overheating. When the curve inverts, a recession follows within the next two years. But it is only after the yield curve reverts that a recession is imminent.
So where do we stand today?
The yield curve has been inverted for roughly a year. Based on the historical pattern, we might predict a recession is on the way.
But the curve today feels strange.
The current level of inversion (-0.96% for the 10y2ys and -1.68% for the 10y3ms) is the deepest since the early 1980s. If the Federal Reserve makes good on its plan for two more hikes this year, this inversion may grow even deeper.
In order to maintain the historical pattern witnessed over the past several decades, an inverted yield curve must first revert prior to a recession. A reversion could happen two ways. Either the Fed significantly cuts short-term rates or long-term rates rise significantly (or a combination of the two).
Neither of these alternatives seem likely in the near term, at least according to the market. Market expectations of the Fed’s rate path, as measured by Federal Funds futures contracts don’t show an easing of policy rates until early 2024. Meanwhile, the 10-year has trended lower after reaching a recent high point back in October 2022. Assuming the 10-year rate remains constant, a yield curve reversion would not occur until early 2025.
Of course the market may be wrong. If the economy begins to contract and inflation subsides, then rate cuts might happen quicker than expected. Meanwhile, if long-term interest rates spring higher, it would put renewed pressure on the economy and hasten the path towards recession.
Yet, it’s hard to shake the feeling that this yield curve is different from what we are used to.
If we are waiting on a reversion to indicate an imminent recession, the market suggests there is still some ways left to go. But perhaps this traditional understanding of the yield curve indicator needs to be re-examined.