Is an Inverted Yield Curve a Predictor of the Next Recession?

By: Scott Fischer, Senior Investment Consultant

By now you have heard that we have had an inverted yield curve for the first time since 2006.  You probably also heard that an inverted yield curve is a leading indicator of an upcoming recession.   As both of these points are true, I would like to explore what an inverted yield curve is and what it means to us and the economy.

What is an inverted yield curve? An inverted yield curve is when the interest rates on short term bonds are higher than the interest rates paid by long-term bonds. This is usually due to investors moving assets to longer term safer investments such as bonds. It can also be propagated by the Fed raising the Fed Funds rate.  Below, we can see a chart showing the 10-year treasury yield (blue), the 2-year treasury yield (teal) and the target fed funds rate (orange).  As the Fed continued to raise the fed funds rate, it pushed the 2 year treasury yield higher until the 2-year and 10-year were within a few decimal points of each other.  We also see in this chart that the fed funds rate yield was actually higher than both the 2-year and 10-year treasury yields. This was the first sign of an inverted yield curve and happened in the 1st quarter of 2019.

Where we are vs a normal yield curve.  Below we can see a chart that looks at the yield curve on December 31st, 2013 and the yield curve in the first quarter of 2019. The dashed line being the healthy yield curve, although the ultra-low interest rate environment we were in at that time led to the yield curve as is was then.  As the fed raised interest rates during 2018, the short term rates increased. In 2019, with investor concerned about a slowing economy, we have seen more investment into longer term bonds. As investment into longer term bonds increases, yields decrease. Thus we have an inverted yield curve.

I have seen many comments from economists recently that suggest an inverted yield curve does not have to predict a recession.  Although I agree with that sentiment, the below graph shows each time the yield curve has inverted since 1967 and each time it has, it was followed by a recession shortly there-after.  Now, there is a first time for everything, but that is a lot of historical data to refute.

As I see it, history can change from what we’ve seen since 1967, but it will most likely take some defensive moves from the Fed on lowering interest rates as well as an end to the trade war with China. We have already seen indications that the Fed will take defensive positions with the recent rate cut. Will we also see an end to the trade war? Time will tell.

This report was prepared by Enza Financial LLC, and reflects the current opinion of the firm, which may change without further notice. This report is for informational purposes only and is not intended to replace the advice of a qualified professional. Nothing contained herein should be considered as investment advice or a recommendation or solicitation for the purchase or sale of any security or other investment. Opinions contained herein should not be interpreted as a forecast of future events or a guarantee of future results.

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