Explainer: Why are Yield Curve Inversions Seen as a Recession Indicator?

Traders work before the closing bell at the New York Stock Exchange (NYSE) on August 14, 2019 in New York City. (Johannes Eisele/AFP via Getty Images)

Recently, the yield curve inverted—albeit only for a couple of days. Pundits are now debating whether this is portending an imminent recession.

But what is the yield curve? What does it mean for the yield curve to be inverted? Do yield curve inversions matter? And is a recession imminent?

What is a Yield Curve Inversion?

Before looking at yield curve inversions it is worth highlighting what the yield curve itself is. The yield curve is just a line connecting the interest rates (or yields) on bonds with different maturities. It illustrates the amount of compensation investors demand to hold a bond for a given maturity.

Typically the yield curve is summarized by taking the difference between interest rates on long-dated government bonds and short-dated government bonds. One of the more popular measures of the yield curve is the difference between the 10-year Treasury yield and the 2-year Treasury yield.

Normally this difference is positive. This is because investors typically require more compensation for holding longer-dated bonds. But occasionally the difference becomes negative, and this is a yield curve inversion.

What Drives Yield Curve Inversions?

Movements in the yield curve are notoriously hard to break down. This is largely because yields are driven by a variety of forces that are difficult to disentangle.

Yields on Treasuries represent the average expected path of the interest rate over a particular horizon. But the expected path of the Federal Reserve’s benchmark rate is driven by underlying forces such as expected inflation and real interest rates. So movement in both of these factors drives yields. Unfortunately, only imperfect measures of expected inflation and real interest rates exist, making it difficult to know what really causes yields to change.

To complicate matters further, yields also include additional factors, which are all bucketed into  the concept of “term premium.” Term premium arises from investors requiring additional compensation for holding longer-term bonds. But unfortunately, the term premium is also unobservable, making it hard to know if yield curve movements are driven by term premium.

So when the yield curve inverts this could be driven by the expected path of real interest rates, inflation, or even changes in term premium. But the reason for the inversion ultimately matters in relation to how one should interpret yield curve inversions.

Why do Yield Curve Inversions Matter?

In one sense, yield curve inversions do not need to matter. There is no definitive mechanism where yield curve inversions cause recessions.

In reference to the yield curve’s ability to predict recessions, Jerome Powell, the Federal Reserve’s Chair recently said that it’s “hard to have some economic theory on why that would make sense”.

Nonetheless, the yield curve has a good track record of predicting recessions. Since 1980, yield curve inversions have preceded every recession, without any false positives.

So how can yield curve inversions predict recessions? One lens is by looking at what the yield curve tells us about Fed interest rate policy. Yield curve inversions represent the market predicting that interest rates are going to go up and then down. This pattern is typically seen when the Fed needs to engineer a “soft landing”— that is, slow the economy without creating a recession—something the Fed doesn’t have a strong track record on.

Is a Recession Imminent?

The Fed is indeed in the process of attempting to engineer a “soft landing” as the economy booms and inflation continues to be well above the Fed’s target. Whether this attempt is successful or not is still to be determined.

But some analysts are already bracing for a recession. Last week Deutsche Bank became the first major bank to forecast a recession in 2023.

“The U.S. economy is expected to take a major hit from the extra Fed tightening by late next year and early 2024” said Deutsche economists David Folkerts-Landau and Peter Hooper.

But the current high inflation environment complicates how to interpret a yield curve inversion. Inflation is currently running at around 8 percent. And if long-term expectations of inflation remain anchored and low, we might naturally expect the yield curve to invert. That is, rates will be high in the short term because inflation is high, but rates will come back down in the long term as inflation is brought back under control. This interpretation might lead one to be more sanguine about the chances of a recession.

The yield curve inversion may not definitively mean a recession is imminent, but it does reflect the difficult environment faced by the Fed as it attempts to quell inflation without bringing economic growth to a halt.