Recently the 10 – 2-year US Treasury yield curve has turned negative propelled by short rates rising much faster than long rates.
The yield curve is a measurement of the health of the economy and provides an outlook on the future direction of interest rates. Historically a negative yield curve has predicted many past recessions and is frequently mentioned by economists and investment strategists as one of their main factors to consider to measure future economic strength. According to the US economist, Edward Yardeni, an inverted yield curve has anticipated ten of the last seven recessions. This is not a particularly great track record. Yardeni feels that too tight a Central Bank monetary policy, rather than the yield curve inversion, creates a credit crunch that normally leads to a recession.
The track record of a recession predictor was quite good in the 1970’s and 1980’s, but it has been much less effective in the 1990’s and the 2000’s. While the yield curve inverted in August 2019 for a short period, the recession of 2020 was totally caused by the pandemic and not the inversion of the yield curve.
Other factors to consider is what yield curve to use in the prediction process. Most strategists use the 10-2-year yield curve. However, many Central Bankers also use the 10 minus fed funds rate and the 10 minus 3 month Treasury bill rate as better indicators. In the case of the latter two yield curves, they both remain positively sloped.
Another factor to consider is the lead time of predicting an upcoming recession. For the last seven recessions the yield curve inversion has a range of lead times from 40 weeks to 77 weeks with an average of 55 weeks or more than one year. It is also important to keep in mind that the predictor signal works much better the longer the yield curve remains inverted.
Regarding the economy, banks typically borrow short term funds and lend out into longer term maturities, creating an interest rate spread profit. When the yield curve is positively sloped, banks’ net interest margins go up and this encourages them to expand their overall lending. On the other hand, when the yield curve inverts, banks’ net interest margins shrink, and this does not encourage them to increase their loan portfolio. Instead, they tend to make credit harder to obtain in these periods.
One of the main reasons that the yield curve inversion is not as good an indicator today than in the past is a result of the Federal Reserve Quantitative Easing policy that buys longer term maturities causing yields to go down. This was not used nearly as frequently in the past as it is today. Even today when the Central Bank is turning more hawkish, they have announced but not yet stopped buying longer term maturities. When they do stop buying longer term maturities, this will cause the longer dated maturity yields to rise.
The probability of an economic recession has most definitely increased with the Central Bank becoming much more concerned about rising inflationary pressures. However, the timing of a possible recession is still very much up for debate. In my opinion the possibility of a recession is more likely in 2023, than in 2022. The stock market historically anticipates an economic recession on average of about six months in advance of a recession.
Furthermore, it will be important to closely watch what happens to longer term maturity yields when the Central Bank stops buying longer term maturities. Also, it is important to monitor other yield curves such as the 10 minus 3 month and the 10 minus Federal Funds Rate curves to see if there is any inversion of these curves.
In the interim, I am raising more cash in my model portfolios with these additional headwinds becoming even more prevalent. But I do not recommend a massive liquidation of equities at this time solely based on the inversion of one yield curve. That would be a real mistake and would materially negatively affect your overall net worth. It is also important to keep in mind that in the past equity markets did well between the first instance of a negative yield curve and a market top preceding any recession.