Is The Yield Curve Inversion Indicative Of A Recession?

The fundamentals of the U.S. economy are currently very strong (high consumer demand, low unemployment and strong corporate earnings etc.). So why are Wall Street and some economists suddenly worried about a recession?

While the future is always somewhat difficult to predict, certain market indicators, specifically the yield curve inversion have shown increasing signs of a possible recession in the future. There are multiple factors at work which could combine to slow the economy – including the Fed raising interest rates and reducing their balance sheet. These factors could combine to slow the economy too rapidly and possibly lead to a recession.

What Is A Recession?

A recession is not a reason to panic. In fact, it is a normal part of the economic cycle. Stocks historically have led the economy out of past recessions. If a recession were to occur, a period of economic expansion of several years typically follows. The average economic expansion is more than four years and the past four expansions prior to the 2020 recession averaged over eight years.

Yield Curve Indicator

The shape of U.S Treasury yield curve is often looked at as a barometer for U.S. economic growth. More specifically, it reflects how the Federal Reserve (Fed) intends to stimulate or slow economic growth by cutting or raising its policy rate.

In “normal” times, the yield curve is upward sloping, meaning longer maturity Treasury yields are higher than shorter maturity Treasury yields. However, when the economy is growing too quickly and inflationary pressures are apparent, the Fed wants to slow growth. One tool that they might use is to raise short term interest rates as they are doing now. In this scenario, shorter maturity securities could eventually out-yield longer maturity securities, inverting the yield curve.
The past six times the 2Y/10Y part of the yield curve inverted a recession followed 18 months later on average. However, the length of time between the quickest time to recession (6 months) and the longest time until recession (nearly 36 months!) complicates the signal and in the Fed’s words, the relationship is probably spurious.

The yield curve signal may not be as robust as it once was as central banks around the world have implemented aggressive quantitative easing programs that have likely impacted market signals. In the U.S., for example, the Fed owns more than 25% of Treasury securities outstanding and continues to reinvest coupon and principal payments into the Treasury market.

While yield curve inversions are a big factor when measuring the risk of recession, they’re not the only factor.  In fact, a yield curve inversion measure is only one of the 10 components that make up The Conference Board’s Leading Economic Indicators Index (LEI).

We acknowledge that recessionary risks have increased given the nuances surrounding current economic dynamics and the potential for the Fed to respond more aggressively.

Our Covenant Wealth Strategies Investment Team is closely monitoring market fundamentals and technicals and are making appropriate tactical shifts in keeping with our strategies, while doing tax loss harvesting as appropriate.

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All index data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.