An inverted yield curve has been one of the most consistent indicators of a recession since 1950. All of the nine major recessions were preceded by a yield curve inversion. Given that the yield curve is currently inverted, can we rely on it to predict as much as we did before?
The yield curve is defined as the spread between the short - term and long - term Treasury bonds, turning negative when the near - term yield exceeds that of the long - term. This means that short - term debt is deemed as riskier than long - term debt. In normal circumstances, the yield curve is upward sloping because investors who own longer term bonds expect to be compensated more for taking on the added risk of tying up their money for a longer period of time. A yield - curve inversion therefore means that there is an expectation of weaker growth in the future. The most commonly followed inversion is the so called "two and ten" (two - year and ten - year Treasury bonds). The two - year Treasury note is very sensitive to interest rate policies that the Federal Reserve sets. Longer - term securities are influenced more by investors' expectations of future inflation (inflation erodes the purchasing power of bondholders). The Fed cut rates in July for the first time since 2008, ending its tightening monetary policy which caused markets to go into a frenzy because investors took this as a sign that trouble is looming.
Historically, it can take up to 34 months for a recession to hit after the yield curve inverts and that is why it is considered as one of the first signs that the economy is shrinking. The yield curve inversion usually ends before the recession actually begins and it cannot predict the length or the severity of the recession. It is important to remember that a yield curve inversion is not a precondition but only a sign that a recession could occur.
However, some have argued that things are different this time around and that a yield curve inversion might not be as accurate of a predictor. Art Cashin, UBS director at the New York Stock Exchange, stated that "the inverted yield curve is slightly suspect because this time it's for a separate reason" - in the past, inversions occurred when the economy was under a tightening policy not an expansionary one. Therefore, the current yield inversion could be signaling that the Fed is not cutting rates fast enough to keep up with the bond market. However, if the Fed cuts rates too much then the economy will not have a "safety net" to fall on if and when a recession actually does hit because the ability to further reduce interest rates will have been exhausted.
The economy expands and contracts in cycles. Currently, the U.S. economy is in an expansionary state and has been as such since 2008. The longest period of expansion occurred from 1991 to 2001 (120 months). The current expansion has surpassed that of the 1990s, making it the longest one since 1854. Given the length of this expansion, the U.S economy is in fact "due" for a contraction (recessionary period) and this is evident in the general slowdown of the economy. Therefore, if the U.S. does enter a recession it would not be anything out of the ordinary and it also does not mean that it will be as deep a recession as the one in 2008.