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What An Inverted Yield Curve Really Means

What An Inverted Yield Curve Really Means

A flattening and inverting yield curve is spooking investors, but now is the time to worry – not panic. Here’s what you need to know now.

On Monday, the yield curve inverted when the interest rate on five-year Treasury bonds slipped below the rate on three-year bonds for the first time since the beginning of the country’s last recession back in 2007.

That’s certainly a worrying sign as such inversions are typically associated with being the sounding alarm for recessions. So worrying in fact, the brief inversion contributed to the Dow plunging more than 800 points on Tuesday. It even caused enough anxiety that Google searches for the term “yield curve inversion” spiked to the highest level on record on data going back to 2004.

Source: Bloomberg.

Joseph LaVorgna, chief economist of the Americas at Natixis, said that the inversion has him “very worried” about what may be coming next. “The yield curve has almost always forecasted the direction of trend growth, meaning when the curve flattens, growth with a lag tends to slow and vice versa when the curve steepens,” he said to CNBC on Tuesday.

But this week’s inversion could be considered more like a partial inversion. A fully inverted yield curve would see the interest rates on two-year Treasury bonds climb higher than the rates on 10-year bonds, which hasn’t yet happened.

Over the last 40 years, every time this has happened, the U.S. economy has succumbed to recession soon afterward. But how soon?

Here’s the thing—and this is why investors shouldn’t panic at this point, but rather prepare—the yield curve is kind of a long leading indicator. In fact, as you can see in the chart below from Bloomberg economist Michael McDonough, on average, there are more than 600 days between the first inversion of the two-year and ten-year spread and the start of the following recession.

While a long leading indicator, an inverted yield curve is one of the most reliable indicators for predicting a recession. The last two times the yield curve inverted, in 1998 and 2008, economists debated whether that time would be different, and in both cases, it wasn’t. A recession soon followed.

Right now, the two-year Treasury rate is at 2.764% and the ten-year is at 2.888%. This is incredibly close, and the closest they have been since the Great Recession ended.

So does that mean we’re on the verge of a recession? Probably, yes, but we’re likely over a year out.

“Typically the 2s/10s has roughly a 16-month lead from when it inverts to a recession and it could be even longer than that,” LaVorgna said. “Much will depend on what the Fed does.”

When the Fed meets next week, it is expected to raise its target interest rate again to 2.5%. This rate is the federal funds rate and is the shortest term interest rate in the economy. Raising the benchmark is already priced into the interest rate on two-year Treasury bonds, which means it won’t be enough to push the economy into a recession.

But what really matters is how the Fed will respond to the yield curve and other macroeconomic clues over the next several months. If the Fed continues to raise rates beyond December, a full inversion of the two-year ten-year spread is all-but guaranteed, which would be a very bad omen for what’s to come. But that’s an “if,” and the Fed may still be able to slow this inversion.

“If the Fed relents later this month and takes off some of those dots, it takes away some of those aggressive rate-hike projections, the yield curve will then stop flattening, it might steepen out a bit, and that would be a sign the economy, at least in the markets’ mind, has some more room to run,” said LaVorgna.

When the Fed meets next week, in addition to its likely announcement to raise the federal funds rate, it will also release its dot-plot projections, which may ease concerns over just how aggressively it will move next year.

“Nothing is preordained. The curve isn’t saying there’s a recession imminently. It says that one is going to happen at some point on the horizon. What the Fed does from here, though, will be central to whether those market fears are realized,” LaVorgna said.

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