Yield curve inversion: Should we trust the alarm?Contributor Alex Dryden
- The yield curve, specifically its potential inversion, has become a trusted signal of impending economic turmoil due to the close historical relationship between inversions and recessions.
- The curve has been flattening since early 2017. However, investors should remember two things: a flatter yield curve is common when the Federal Reserve is raising rates, and the curve can stay flat for a long period of time.
- In addition, this indicator may no longer be reliable. Post-financial crisis monetary policy has been both extreme and unorthodox, which may have artificially warped the yield curve.
- Rather than rely on the yield curve, investors should instead look at the U.S. forward market for short-term rates, which is an empirically superior signal and currently shows no signs of distress.
Understanding the curve
The yield curve, specifically its potential inversion, has become one of the most trusted signals of impending economic turmoil. The reason for this is shown in Exhibit 1: an inverted yield curve (typically when the U.S. 2-year Treasury yield is higher than the U.S. 10-year Treasury yield) has almost always been followed by a recession.
In theory, monetary policy typically drives the front end of the curve and economic conditions impact the back end. An inverted yield curve occurs, at least in one iteration, when the Federal Reserve (Fed) raises interest rates, forcing up the front end of the curve, and economic conditions deteriorate, pushing down the back end. When the curve inverts, it suggests that monetary policy is too tight at a time when growth is slowing. This may cause a recession.
Yield curve discussions have become particularly relevant in recent months, with the curve presently within 0.30% of inversion after gradually flattening since late 2016. As we near inversion, investors have become increasingly nervous that we are approaching the end of the cycle and are pondering whether to de-risk their portfolios. That said, there are a few aspects to consider when assessing the likelihood of a recession through this lens: first, yield curve flattening is very common at this stage in the cycle, especially when the Fed is raising interest rates; and second, the yield curve can stay flat for very long periods of time before inverting. In the late 1990s, for example, the yield curve remained flatter than today’s level for nearly three years before finally inverting in early 2000. With this in mind, the steepness of the curve is simply reflective of monetary policy: steepness suggests easy policy, inversion suggests that policy is too tight. Presently, the yield curve is telling us that monetary conditions are tightening but not yet too tight.
Exhibit 1: U.S. 10-year yield minus U.S. 2-year yield
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1 (Don’t Fear) The Yield Curve, Eric Engstrom & Steven Sharpe, June 2018.
2 The Bloomberg Barclays U.S. Aggregate has returned an average of 2.1% per year over the last five years.