The Yield Curve and Its Relation to Recession

Just as the yield curve can be a good indicator of inflation, it can also be an indicator of an impending economic recession. As the yield curve flattens, so does our economy and the odds of a recession occurring in the next few years increases. As of December 3, 2018 the U.S. has inverted for the first time since the 2008 recession. An inversion in the yield curve occurs when the yield on short-term bonds are higher than the yield on long-term bonds. We call this an inversion in the yield curve because a “normal” yield curve has higher yields on long-term bonds as opposed to short-term ones.

How the Yield Curve Predicts Recession

In past recessions, the yield curve has turned negative, or inverted roughly 2-3 years before a recession, or at least the recognition of one. Often times an economy can be in a recession before it is even recognized. Historically, the yield curve has been a pretty accurate predictor of an impending recession, but it is not the end-all-be-all. Sometimes, rates may rise one more time before the curve finally falls flat. The reason the yield curve is a predictor of recession has all to do with investor behavior. When the yield curve is flattening or inverting, investors will start buying up more long-term bonds because they believe the economy will begin to fail soon, thus making a short-term bond a riskier investment. The increase in popularity of long-term bonds begins to drop the yield/interest in them, it’s a simple supply and demand theory. When you couple the shrinking long-term yields, with the now increasing short-term yields, the yield curve starts to flatten until the point that it eventually inverts.

Historic Yield Curve Inversions and Predictions

In our nation’s history, the yield curve has been extremely accurate in predicting the future health of our economy. The curve inverted before or predicted every major recession in recent history including 1991, 2000, and 2008.

The Great Recession of 2008

The first indication of the 2008 recession happened about 2-years prior when the yield curve first inverted in December 2005. The Fed was worried about the housing market and had been raising rates for over a year which caused this initial inversion. The yield on 2-year bonds was about .02 points higher than those on long-term bonds which indicated investors were not confident in the short-term outlook on the economy and began taking on long-term investments even though their return was lower.

At this point the yield curve had been inverted for quite a while, but the Fed haphazardly continued to raise short-term rates until they hit 5.25 percent in June 2006, which was up a full point from the 4.25 level they were at in December 2005. Rates continued to rise and the Fed continued to ignore the now worsening inversion because they believed there was sufficient financial reserves to protect against any type of recession. They were wrong.

The Fed continued to raise rates and ignore the yield curve until September 2007, when they finally lowered rates, but it was too little too late. The Feds continued to lower rates into 2008 to the point that they actually zeroed out, and the yield curve was normal, but it was far too late for that to have any effect. The United States had entered The Great Recession and the worst economic turmoil the U.S. had faced since The Great Depression.

Yield Curve and Its Relation to Recession

The Current Yield Curve and Moving Forward

Although the yield curve can indicate financial turmoil for the U.S., it does not necessarily translate to a global level. As it stands right now Russia, China, and Brazil all have relatively normal shaped yield curves meaning any slowdown in the U.S. would not carry over to the global economy.

Only time will tell how the yield curve drama pans out, but it important to remember that the yield curve is not inverted yet, and even if it doesn’t invert, we shouldn’t expect a recession for another 2-3 years. A recession is not imminent, but it is something to be wary of and keep an eye on.

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