Inverted Yield Curve and Why It Predicts a Recession

Why the Yield Curve Is Inverting Now

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An inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. It's an abnormal situation that often signals an impending recession.

In a normal yield curve, the short-term bills yield less than the long-term bonds. Investors expect a lower return when their money is tied up for a shorter period. They require a higher yield to give them more return on a long-term investment.

When a yield curve inverts, it's because investors have little confidence in the near-term economy. They demand more yield for a short-term investment than for a long-term one. They perceive the near-term as riskier than the distant future. They would prefer to buy long-term bonds and tie up their money for years even though they receive lower yields. They would only do this if they think the economy is getting worse in the near-term. 

What an Inverted Yield Curve Means

An inverted yield curve is most worrying when it occurs with Treasury yields. That's when yields on short-term Treasury bills, notes and bonds are higher than long-term yields. The U.S. Treasury Department sells them in 12 maturities. They are:

  • One-month, two-month, three-month, and six-month bills.
  • One-year, two-year,  three-year, five-year, and 10-year Treasury notes.
  • 30-year bonds.

During healthy economic growth, the yield on a 30-year bond will be three points higher than the yield on a three-month bill.

An inverted yield curve means investors believe they will make more by holding onto a longer-term Treasury than a short-term one. They know that with a short-term bill, they have to reinvest that money in a few months. If they believe a recession is coming, they expect the value of the short-term bills to plummet soon.

They know that the Federal Reserve lowers the fed funds rate when the economy slows. Short-term Treasury bill yields track the fed funds rate.

So why does the yield curve invert? As investors flock to long-term Treasury bonds, the yields on those bonds fall. They are in demand, so they don't need as high a yield to attract investors. The demand for short-term Treasury bills falls. They need to pay a higher yield to attract investors. Eventually, the yield on short-term Treasurys rises higher than the yield on long-term bonds and the yield curve inverts.

Recessions last 18 months on average. If investors believe a recession is imminent, they'll want a safe investment for two years. They'll avoid any Treasurys less than two years. That sends demand for those bills down, sending their yields up, and inverting the curve.

Why the Yield Curve Is Inverting Now

On December 3, 2018, the Treasury yield curve inverted for the first time since the recession. The yield on the five-year note was 2.83. That's slightly lower than the yield of 2.84 on the three-year note.On December 4, the inversion worsened. The yield on the five-year note was 2.79, while the yield on the three-year note was 2.81.

Investors are saying that the economy will be a bit better in five years than in three years.

The Federal Open Market Committee will finish raising the fed funds rate in two years. It's planning to raise it to 3.5 percent in 2020. Investors are worried it could trigger an economic slowdown in three years if the Fed overshoots and raises rates too high. They believe the economy will be stronger in five years.

This small inversion could be temporary. If it continues or worsens, then it could predict a recession. 

When the Inverted Yield Curve Last Forecast a Recession

The Treasury yield curve inverted before the recessions of 2000, 1991, and 1981.

The yield curve also predicted the 2008 financial crisis two years earlier. The first inversion occurred on December 22, 2005. The Fed, worried about an asset bubble in the housing market, had been raising the fed funds rate since June 2004. By December, it was 4.25 percent.

That pushed the yield on the two-year Treasury bill to 4.41 percent. But the yield on the 10-year Treasury note didn't rise as fast, hitting only 4.39 percent. That meant investors were willing to accept a lower return for lending their money for 10 years than for two years.

The difference between the 2-year note and the 10-year note is called the Treasury yield spread. It was -0.02 points. That was the first inversion.

A month later, on January 31, 2000, the Fed had raised the fed funds rate. The two-year bill yield rose to 4.54 percent. But that was more than the 10-year yield of 4.53 percent. Yet the Fed kept raising rates, hitting 5.25 percent in June 2006. The fed funds rate history can tell you how the Federal Reserve has managed inflation and recession throughout the years.

On July 17, 2006, the inversion worsened again when the 10-year note yielded 5.07 percent, less than the two-year note of 5.12 percent. This showed that investors thought the Fed was headed in the wrong direction. It was warning of the impending “subprime mortgage crisis.

Date Fed Funds  3-Mo  2-Yr  7-Yr  10-Yr 2 to 10 yr. Spread
Dec. 30, 2005      4.25 4.09 4.41 4.36 4.39 -0.02
Jan. 31, 2006      4.50 4.47 4.54 4.49 4.53 -0.01
Jul. 17, 2006      5.25 5.11 5.12 5.04 5.07 -0.05

Unfortunately, the Fed ignored the warning. It thought that as long as long-term yields were low they would provide enough liquidity in the economy to prevent a recession. The Fed was wrong.

The yield curve stayed inverted until June 2007. Throughout the summer, it flip-flopped back and forth, between an inverted and flat yield curve. By September 2007, the Fed finally became concerned. It lowered the fed funds rate to 4.75 percent. It was a half point, which was a significant drop. The Fed meant to send an aggressive signal to the markets. 

The Fed continued to lower the rate 10 times until it reached zero by the end of 2008. The yield curve was no longer inverted, but it was too late. The economy had entered the worst recession since the Great Depression. The current fed funds rate determines the outlook of the U.S. economy. Word to the wise: Never ignore an inverted yield curve.