Last week, the U.S. treasury curve briefly “inverted” for the first time since 2019. Inversions are unusual because longer term yields are typically higher than shorter term yields as investors want to be compensated for taking additional duration risk in their fixed income holdings. So, what does this all mean?
What is an Inverted Yield Curve
The spread between the two-year U.S. treasury and the ten-year U.S. treasury is a proxy for the difference between long-term and short-term interest rates, and historically has been a relatively accurate predictor of future economic activity. Since 1960, every U.S. recession was preceded by a negative 2-10 year spread, otherwise known as an inverted yield curve. Additionally, a negative 2-10 year spread was always followed by an economic slowdown and, except for one time, by a recession.
However, a “typical” market cycle is seven years, and with the lag between inversion and slowdown (and the peak in equity markets) as long as two years, the predictive power is perhaps less than commonly advertised. A second potential wrinkle in this relationship is that the yield curve inverted in 2019 prior to the pandemic-driven recession in 2020. Would a recession have occurred without the pandemic? We’ll never know, but it seems unlikely given that economic variables like new home sales were making new highs in January of 2020.
The Bottom Line
At Invariant, we think about yield curve inversion as one part of a mosaic of economic indicators. Forecasting future economic developments is a complex endeavor. Yield curve inversion merits paying attention to, and if other leading economic indicators such as significant year-over-year increases in jobless claims, declines in LEI (Conference Board Leading Economic Index), substantial credit spread widening, etc., the probability of a recession is heightened, and portfolio adjustments may be warranted. Need a second opinion on your financial scenario and/or investment portfolio? We’d love to hear from you at Amber@invariantinvestments.com.