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Can Inverted Yield Curve Predict Next Recession This Time?

It is impossible to truly predict when markets or economies will start to decline. But one key indicator, an inverted yield curve, has preceded the last three recessions in the U.S., and right now, it suggests that another one might be on the way.

As the saying goes, “when the U.S. market sneezes, the rest of the world catches a cold”, and with the historical impact of the U.S. economy on the Hong Kong economy, a downturn in the U.S. market may signal a downturn in the Hong Kong market as well.

What is a yield curve?

A yield curve plots the returns of various U.S. Treasury Bills on its Y-axis, and those bills’ different maturities on the X-axis. A normal yield curve slopes upwards; the longer a bill takes to mature, the higher its returns. But when that curve inverts, it starts to slope downward, meaning that short-term investments have begun paying higher rates than long-term ones.

An inverted yield curve traditionally signals an upcoming economic downturn or market retreat from at least two perspectives. First, long-term yields tend to match up with long-term inflation levels; a low long-term yield suggests that the market’s expecting lower inflation in the future, which in turn signals weak demand for goods and services– never good news for any economy. Secondly, long-term yield represents the accumulation of a series of expected short-term interest rates. For example, the 10-year Treasury yield amounts to 10 expected 1-year interest rates. If long-term yields fall below short-term ones, the market’s expecting lower interest rates in the future \– and the Fed only cuts rates in recessions.

Of course, some parts of a yield curve can slope downward, even while the overall curve still trends upward. In general, as more and more of a curve slopes downward, and points on the curve farther and farther apart begin to invert, investors feel more confident that a downturn is coming– and think it will arrive sooner. So if 3-month yield beats 10-year yield, that may be a stronger signal of bad news for the market than if 3-year yield beats 5-year yield.

What does history tell us?

Historically, a downward curve between 2-year and 10-year Treasury yields has indicated an economic or market declines on the way. If the curve heads down between 3-month and 10-year Treasury yields, that usually means bad times are imminent. Consider the following table[i]:

Date of Inversion––– 2-Year and 10-Year Yields Date of Inversion––– 3-Month and 10-Year Yields S&P500 Downturn Period S&P500 Peak to Trough Correction Economic Downturn Period Real GDP Peak to Trough Decline
8 Mar 1990 N/A 9 Jul 1990 to 10 Aug 1990 -18.41% Q4 1990 to Q1 1991 –5.43%
2 Feb 2000 7 Jul 2000 28 Aug 2000 to 17 Sep 2001 -36.49% Q1 2001 to Q3 2001 -0.44%
31 Jan 2006 17 Jul 2006 10 Aug 2007 to 2 Mar 2009 -56.24%  Q1 2008 to Q2 2009 -11.08%

Source: U.S.Treasury Department, Yahoo! Finance, Federal Reserve Bank at St. Louis

In short, inverted yield curves have preceded the last three U.S. recessions, each arriving a few months to one and a half years before the stock market started to retreat.

Fasten your seatbelts…

The market first started fretting when the 3-year and 5-year U.S. Treasury yields became inverted on 3 Dec. 2018. The 2-year and 5-year Treasury yields also inverted only days later.  The key 2-year to 10-year portion of the yield curve is still sloping upward – but just barely, with a narrow difference of just 18 basis points as of 10 Jan. 2019.

U.S. markets seem to have taken the hint already, given their very rough December. And as the yield curve displays more and more of these historical warning signs, investors everywhere should keep a close eye on the market, and prepare for the possibility of a bearish near future.

[i]Source:

Yield curve data: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yieldAll

S&P500:https://finance.yahoo.com/quote/%5EGSPC/

U.S. GDP data: https://fred.stlouisfed.org/series/A191RO1Q156NBEA

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