What the Inverted Yield Curve Says About the Next Recession
A yield curve inversion, when rates for two-year US Treasury notes rise above those for 10-year notes, has preceded every recession since the 1960s. The first clear inversion in 15 years happened in July 2022, although there were brief and shallow inversions in August 2019 and April 2022.
All that is old news. What’s happened since July is the inversion, unlike all others since the early 1980s, has become deeper so that the two-year yield is now almost 80 basis points, or 0.8 percentage point, higher than the 10-year yield. This inversion is only exceeded by the ones of 1978 to 1982, when the Federal Reserve chairman Paul Volcker was ramping up benchmark rates to double digits to reverse high inflation at the cost of two long and deep recessions. Investors are naturally now asking whether the next recession will be longer and deeper than any of the previous 40 years?
To answer the question, we must begin by distinguishing monetary inversions from real economy inversions. Monetary inversions are the result of Fed rate increases. Those push up the cost of short-term borrowing but also reduce the expected amount of future inflation, which can bring down long-term yields. The subsequent recession is caused by Fed tightening, the inversion is only a signal of that tightening.
Real economy inversions are more complex. They reflect market opinions that there will be a recession. In recessions consumers and companies try to pay down debt rather than take on new debt. Yet some consumers are forced to borrow to make ends meet, and some companies are forced to borrow to finance inventory that cannot be sold and cover short-term bills. Investors prefer to lend to entities that don’t need the money, so they charge high rates for these shaky short-term loans.