Over the past year, the Federal Reserve has fought inflation vigorously. Interest rates were increased at their quickest rate in forty years, while the Fed’s balance sheet, which doubled during the epidemic, was simultaneously reduced. These steps have resulted in a decreased trend in inflation, but they have also put the economy in danger of entering a recession.
In fact, Fed policymakers now anticipate a little recession in the United States before 2023 ends. That prognosis coincides with an inversion in the U.S. Treasury yield curve, an indicator that has preceded every recession since 1955. Here are some specifics.
Yield curve inversions signal a lack of confidence in the economy
Under normal circumstances, U.S. Treasury yields form an upward-sloping curve when plotted graphically, meaning bond interest rates rise as bond durations lengthen. For instance, a 10-year Treasury note pays more than a 3-month Treasury bill. That happens because long-dated bonds are riskier than short-dated bonds, so investors demand greater compensation. A 10-year Treasury leaves more room for inflation to reduce returns, and it increases the risk that the bondholder will miss other investment opportunities (i.e., because funds are locked up).
However, the curve can invert — a situation in which short-term Treasuries pay more than long-term Treasuries — when investors lose confidence in the economy. Under those circumstances, short-term Treasury yields are higher because investors expect interest rates to rise in the near term, and long-term Treasury yields are lower because investors expect the higher cost of borrowing to hurt the economy, ultimately forcing the Federal Reserve to lower interest rates.
Yield curve inversions have been an accurate recession indicator
The U.S. economy has gone through 10 recessions since 1955, and each one was preceded by a yield curve inversion between the 10-year Treasury and the 3-month Treasury. The lag time varied from six months to two years, but the trend is still noteworthy. That portion of the yield curve is once again inverted today, as shown in the chart below.
