The Yield Curve Says A Recession’s More Likely, And The Yield Curve Is Never Wrong

The Yield Curve Says A Recession’s More Likely, And The Yield Curve Is Never Wrong
Stéphane Renevier, CFA

about 2 years ago2 mins

If there’s one leading indicator that deserves its star on the Hollywood walk of fame, it’s the yield curve (the blue line above). The yield curve – which compares 10-year bond yields to 2-year bond yields – gives you a remarkably accurate snapshot of the health of the US economy, and it’s even correctly predicted 100% of past recessions. Here’s how it works.

10-year bond yields are almost always higher than 2-year bond yields, as represented by a positive value of the yield curve on the right-hand Y axis. That makes sense: investors are taking on more risk by holding an asset for longer, so they expect to be compensated with better returns. But how much higher 10-year yields are – reflected by how steeply the yield curve rises or falls – depends on the economic growth outlook.

When the Federal Reserve (the Fed) tightens monetary policy, investors expect lower growth and lower inflation further down the line. That sends 2-year yields up and 10-year yields down. And as those expectations start to come good and the environment starts to worsen, the risk of recession rises (according to a Fed measure of recession probability: the purple line on the chart above). We’ve seen that happen on a few occasions in the last couple of decades – namely ahead of the tech crash in 2002, the global financial crisis in 2008, and the Covid crash in 2020 (albeit it to a lesser degree).

So what is the yield curve telling us now? Well, it’s been flattening significantly over the past few months, suggesting that investors are expecting growth to decelerate sharply – if not fall into recession territory. That expectation isn’t reflected in the NY Fed recession probability yet, but if history is anything to go by, you should anticipate a negative shift in the narrative in the next few months. Don’t say we didn’t warn you…

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