Is the Current Yield Curve Signaling a Recession?

This week, Craig Siminski, of CMS Retirement Income Planning, shares an article discussing the current yield curve and what it might mean for the economy:

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.

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 early July 2022, and in November and December the difference reached 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%, for a difference of 0.84%.

Other short-term Treasuries have also offered higher yields; the highest yields in late December were for the six-month and one-year Treasury bills. (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. 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.

The three-month and 10-year Treasuries have been inverted since late October, and in December the difference was often greater than the inversion of the two- and 10-year notes.

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…

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Craig Siminski is a CERTIFIED FINANCIAL PLANNER™ professional, with more than 25 years of experience. His goal is to provide families, business owners, and their employees with assistance in building their financial freedom.

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