So the yield curve has inverted briefly two times this past week.
This past week and for a lot of people, an inverted yield curve is one of the strongest signals that a recession could follow. Maybe not right away, but at least in the next couple of years.
Long-term interest rates are typically higher than short-term interest rates, this is how a typical yield curve goes. However, when a yield curve inverses, what that means is that the short-term interest rates become higher than long-term interest rates.
Yield curve inversion can be a concern because:
1) Bond investors could be expecting an economic contraction lowering demand for short-term bonds, thus increasing the yield or the interest rate.
2) A flat inverted yield curve could deter lending by banks. For example, if the long-term interest rate is the same or lower than the short-term interest rates, banks might not lend as much.
So the inverted yield curve has preceded the past six or seven recessions (check the chart below). Recession periods are shown in grey.
This is the 10-year Treasury minus the 2-year Treasury. Once it goes below zero, this is when the yield curve inverses. So every time that yield curve has inverted, there's been a recession.
Also, this has been the case when you compare the 10-year Treasury and the 3-month Treasury; every time it has inverted, there has been a recession that has followed (check the chart below).
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The US 10-year / 2-year Treasury yield curve briefly inverted on Tuesday and Thursday of this past week for the first time since September of 2019. However, you'll see that the U.S 10-year versus 3-month treasury yield is not even close to inverting, as it is looking to be in a healthy and significant uptrend.
Arturo Estrella and Frederic Mishkin, they wrote one of the first studies regarding yield curves and recessions, and according to our model, we currently have a 5% probability of recession based on the 3-month versus 10-year treasury spread.
However, if we insert the current 10-year versus 2-year difference into their model, then the odds of the recession jump to almost 25%.
source: Arturo Estrella, Frederic Mishkin
In a different study, from Duke University, Professor Campbell Harvey reported in 1986 that when the yield curve stays inverted for a calendar quarter, then the odds of recession become very high. source: MarketWatch
Increase in Recession Risk
For recession risk to increase substantially more from here, we need two things.
1) We need the 3-month yield to rise above the 10-year yield.
2) We need the yield curve to Stay inverted for longer than some days.
If the yield curve stays inverted for an entire quarter, this significantly increases the risk of recession.
An interesting note is that the average time from the yield curve aversion to the next recession has averaged about 16 months, So over a year, and the range has varied from 6 months to 24 months. source: Bloomberg
The Other Side
S&P 500 performance after 2-10 year U.S. Treasury yield inversion
Marco Kolanovic, JP Morgan's Chief Global Market strategist, says that he believes the stock market has room to run even after the yield curve inversion. He adds that it takes around a year for stocks to peak after the point of the curve inversion, and the S&P 500 usually trades Higher by 15% during that period.
source: CNBC
Summary
Clearly, there are a lot of things going on here. The 10-year versus the 2-year Treasury spread has inverted for the first time since 2019, and this is starting to be a concerning indicator, however, the 3-month and 10-year spread has not inverted.
We need to monitor the situation and see where all these interest rates trend, and whether the yield curve will stay inverted for a longer time.
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