What is the Yield Curve and Why Does it Matter?
Written December 5, 2018
You might be hearing this phrase a lot lately: the inverted yield curve, a.k.a., the harbinger of doom.
What is an inverted yield curve? It’s when a longer-term Treasury bond’s yield drops below a shorter term bond’s yield. Case in point: the 5-year Treasury yield fell below the 2-year Treasury yield on Tuesday, December 4th, meaning that you’d earn a higher interest rate buying 2-year Treasury bonds than 5-year ones. It’s been said that a recession in imminent when this type of thing happens, which is what sent the market reeling on Tuesday.
Just when things were starting to look up, too!
Is it true? Does an inverted yield curve cast a curse on the economy? Let’s look at history for clues.
The chart above shows times the 10-year Treasury yield has dropped lower than the 2-year Treasury yield (when the green line crosses below the black line) and when recessions have happened (the gray bars). As you can see, the 10-year Treasury yield is still about 0.5% above the 2-year Treasury yield, so we haven’t seen the yield curve invert where it matters most.
Since 1955, recessions have been preceded by that kind of inversion pretty much every time.
So the next question is how much time passes between the yield inversion and a recession.
The chart above answers that question. The lead time has historically been anywhere from 5-17 months. The last time the yield curve inverted was August 2006. The top of the market was October 2007; 14 months afterward the gain from August 2006 to October 2007 wasn’t trivial either with the S&P 500 up 23%.
But wait a minute; we haven’t even seen a proper 2-year: 10-year yield curve inversion yet. And if we do, a recession won’t probably happen for a few more months.
Let me add, however, that this is a big indicator that we watch. A flattening of the yield curve isn’t a be-all-end-all warning alarm, but it does increase the risk of recession. In fact, what we’re seeing is lining up with our predictions of a recession at the end of 2019 or sometime in 2020.
Are there circumstances that could change that view, like a longer, deeper trade war? Of course. But, just like it was back in 2015, calling the end of the bull market here is premature.
We simply aren’t there yet.
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