Deep yield curve inversion provides caveat amid rising optimism

Probably the most notorious recession indicator, an inverted yield curve always attracts attention. One such example of this is, well, now. Taking the most commonly referenced 10Y-2Y maturities, the yield curve is currently at its deepest level of inversion since 1981. But does this really mean anything? 

Well, the first step is to assess its historical significance, before analysing if that is indicative of what could happen next. In the below chart, we have plotted the yield curve going back to the 70s, marking with a red dotted line the point of inversion. The shaded yellow areas show periods of recessions. 

The chart shows an indicator which has been intriguingly accurate, although not perfect. We can see the curve inverted briefly in 1998, however a recession did not follow. This was amid the Long Term Capital Management (LTCM) collapse, when Russia defaulted on its debt. The Fed immediately cut rates, helping to stave off a recession. The other scenario which proved to be a false alarm was the brief inversion in August 2019. 

However, if we omit these temporary inversions and instead focus on the episodes whereby the yield curve was inverted for longer than six months, we get an ominous result – in the last forty years, every single time this has persisted for six months, a recession has followed. 

I say ominous because today, we are in the thirteenth month of inversion, the delta first going negative in July 2022 (it dipped below zero for a day in April 2022, but quickly bounced back before “permanently” breaking back down in July 2022).

Further, if we look at the time between the yield curve first inverting and the subsequent recession, it has varied between thirteen and eighteen months. We are now in the thirteenth month of inversion. 

Will there be a recession?

While all this sounds ominous, it is important to remember that we are currently in a highly unusual situation. Coming out of the black swan of all black swans, the COVID pandemic, is unusual enough. But there is also the matter of a bespoke combination of high inflation (although that has softened), severely tightened interest rates and record unemployment. 

Despite rates being hiked from near zero to above 5%, the economy has been remarkably resilient. Unemployment is at 3.6%, meaning it could even be too good, with concern that a still-hot economy needs to see at least a little bit of loosening in the labour market to strike the 2% inflation target, especially as wages continue to rise. 

The inflation crisis of last year (that is not to say it’s over yet!) can perhaps only be compared to the 1970s, and even then, we saw interest rates approach 20% – a far cry from today when a highly financialised economy is almost impossible to imagine under such a burden. 

In truth, it is difficult to compare the current macro situation to anything. A quick glance at sovereign debt will tell you all you need to know about the fact that rates cannot stay high forever. They will need to come down, and the market is betting with increasing confidence that we are now approaching that home stretch. 

The yield curve simply reflects this situation. With rates expected to come down, the yield curve is of course inverted. And historically, rates have been cut when the economy is struggling, the Fed stepping in to prop it up. Of course this scenario is again possible, however it should be noted that the Fed chair Jerome Powell said that the organisation was no longer expecting a recession at the FOMC meeting last week. 

Should this prediction prove correct, the mythical “soft landing” will have been achieved. It will also be one of the few occasions where the infamous inverted yield curve would have proved a red herring. But to borrow the most overused phrase from 2021, these really are unprecedented times, so all bets are live.