The yield curve is one of the best leading economic indicators, and an inverted yield curve (short-term interest rates higher than long-term interest rates) has preceded all US recessions during modern times. This isn’t just a coincidence—it also makes logical sense because the yield curve drives bank lending.
Banks borrow at short-term rates and lend at long-term rates, and the spread between short and long government rates is their potential profit on the loans made. Inverted yield curves can signal weaker bank lending fundamentals because they affect banks’ profit margins. Because inverted yield curves mean short rates are above long rates, they signal potentially weaker bank lending, which can hurt economic expansion.
So, when you hear pundits talking about the yield curve, it is important to understand the treasury maturity components they are measuring. The financial markets and the media like to define the yield curve in many different ways but most commonly as the difference between the yield on a 2 year Treasury and a 10 year Treasury. This measurement is a good proxy, but it does not mean it is the most accurate or the correct yield curve to help predict recessions.
When I discuss yield curves and a yield curve inversion, I reference the difference in yield between a 3 month Treasury and a 10 year Treasury. Because when we discuss the yield curve, we need to refer to the distribution of bond yields across all maturities from one borrower. Example: Banks do not pay savings account interest at the 2 year Treasury rate—they pay 3 month Treasury rates. Remember, Banks’ core business is to borrow short (e.g., deposit accounts) to fund longer-term loans (e.g., mortgages, car loans, etc.).
When the yield curve is measured correctly, it isn’t as flat as headlines claim. More importantly, one significant criterion is necessary to filter yield curve inversions correctly. The 3 month Treasury / 10 year Treasury yield curve needs to stay inverted for at least 30 days. This single factor has provided 100% accuracy in predicting a future recession within the next 24 months.
Remember, just because an inverted yield curve between 3 month Treasury and 10 year Treasury yields has had a 100% accuracy rate over the past 40 years does not guarantee it will continue to be 100% accurate. There is always a danger in relying exclusively on statistics to warn about recessions. Statistics do not cause recessions; myriad economic, sentiment, and political factors cause recessions, and statistics only measure them.
An inverted yield curve is not a timing tool, and it is not a be-all-end-all leading indicator because no recession starts immediately after 30 days of inversion. Still, an inverted yield curve is an excellent tool to coordinate with other economic, political, and sentiment indicators.
It is impossible to predict the amount of time that will elapse between a yield curve inversion and the beginning of a bear market, and a lot depends on how central banks respond to the inversion. Inversions can make investors fearful of imminent recession, and that fear gets baked into prices. The beauty is you now know that many yield curve inversions are miscalculated and take months to transform. This uncertainty can lead to significant returns after the yield curve inverts. So, remain invested and capture the upside surprise few expect.
In closing, the 3 month Treasury and 10 year Treasury yield curve did not invert over the last few weeks and is not inverted. There is currently a difference of almost 2 percentage points—plenty to incentivize bank lending and for markets to climb the wall of worry this year.
A widely discussed fear of a false factor is a positive.