How The Yield Curve Forecasts Recession Risks

The yield curve predicts U.S. recessions remarkably well. In March, the yield curve hinted at a U.S. recession. Today, the inversion is broadening as the Fed hikes rates. A U.S. recession may coming. Here’s how the yield curve works and why it matters to financial markets.

Economists aren’t prized for their forecasting skills. The yield curve, on the other hand, has a strong track record in calling recessions. The term structure of interest rates, which is the difference between short and long-bond yields, forecasts recessions relatively accurately. The yield curve has got a recession forecast wrong just once in the past 40 years according to Nicholas Burgess of Oxford University. That’s impressive.

The yield curve is also a leading indicator of recessions since it calls recessions up to 18 months before they occur. So, the yield curve is historically among the best tools for forecasting a recession. When the yield curve inverts, you should worry. Unfortunately, now’s the time to worry. Worse, if the Fed stays on course, that inversion will increase in depth and breadth.

The yield curve does provide a mass of information, changing minute by minute. That can be confusing, so the New York Fed researched how best to interpret it in this paper. They found that the spread between three-month and ten-year yields was most predictive of recessions, though it’s a pretty close call.

Ideally, in the researchers’ view, the spread should have a negative monthly average to predict a recession rather than just a temporary dip. It also appears that deeper inversion may make the signal more powerful. Not everyone agrees with that view entirely, but most take the view that short rates rising above long rates does not bode well for the U.S. economy and deeper and longer inversion can make the signal more robust.

Currently, the Canadian yield curve shows some inversion, but yield curves in Japan and Europe are generally not inverted. However, many central banks are expected to raise rates. That would raise the short end of the curve, creating inversion given the term structure of interest rates is quite flat globally. So the international picture may worsen.

Like any good forecast there’s also two clear reasons why the yield curve works. Knowing this is helpful. It means the forecast is less likely to be the result of accidental number crunching.

First when short term yields rise above longer term yields, that’s a big signal to banks. With an inverted yield curve, banks can make more profits from short-term lending, than from longer-term lending. That’s unusual. It can mean pulling back on financing bigger, longer term projects such as new factories and other big investment projects. That sort of pull-back in investments that help economic growth is exactly what we see in many recessions.

Secondly, the Fed raising rates is generally what pushes up shorter term interest rates. They often do this late in the economic cycle, when the economy may be starting to overheat. If we’re late in the economic cycle, that too can mean a recession is not far off. That’s exactly what’s happening now. High inflation and very low unemployment may be signs the U.S. economy is stretched currently.

Of course, we’re currently seeing one of the most aggressive patterns of rate hikes from the Fed in decades. Interestingly, the Fed knows about the yield curve’s forecasting power too. There’s a chance they ease off on hikes precisely because of the yield curve’s inversion. They don’t want a recession either. However, for the time being rampant inflation appears the more pressing concern for the Fed. It’s not an easy call, but the Fed may tolerate a recession to tame inflation.

You can see the latest U.S. Treasury yield curve data here. Currently it’s inverted from six-month out to ten-year maturities. That’s relatively broad inversion, and a bad sign for growth. In terms of the positives, the yield curve is fairly flat right now, not deeply inverted. Plus that all-important metric of 10-year less 3-month maturities is not inverted at the time of writing.

However, we can be reasonably confident inversion at the short end is coming soon if the Fed continues to hike short term rates as planned. Markets currently see the Fed raising rates around 2% over the rest of 2022, that’s almost certainly going create inversion of the yield curve when comparing three month to ten year yields. Of course, this assumes the long-end of rates doesn’t move up much, but unless long-term inflation fears really take hold, that seems unlikely.

That the yield curve is signaling recession is unsurprising. Other metrics agree. There’s a long list including: the current bear market in stocks; increasing talk about recessions; concerns about corporate earnings; early signs of weakness in housing; a softening jobs markets; together with the observation that U.S. economic growth was negative Q1. All signaling a pending recession. A recession may even already be here.

However, as an investor, it is important to remember that much of this may be priced in to markets. The very reason for weak stock returns over 2022 so far, may be the markets starting to adjust to a coming recession, or at least a reasonably mild one.

The severity of any future recession is important. Recession conjures up memories of the Great Financial Crisis of 2007-8 and the pandemic recession of 2020. As the two most recent recessions, that’s understandable. Remember though, those were both unusually severe recessions. So even if a recession is on the horizon, it may not be quite so disruptive as the two most recent ones.

Lastly, as of right now, the key metric of three-month yields hasn’t inverted below the 10-year yield. Many suspect that is the most robust recession flag. There’s still some hope we could dodge the bullet. However, if the Fed remain on their current aggressive rate trajectory, we may see that invert in later this year.