By Tim Courtney, Chief Investment Officer
The last eight economic downturns in the U.S. have occurred within 24 months of the bond yield curve “inverting.”1 The yield curve is said to have inverted when the yields on longer term bonds (like the 10-year Treasury bond) are lower than the yields on shorter term bonds (like the 2-year Treasury). Because of its record of presaging recessions, many investors have been waiting for the next recession since the yield curve inverted in July 2022. However, some are questioning whether the inversion is still an effective signal.
There certainly is something interesting going on with yields when an investor can earn a better yield through a bond with a shorter maturity. Normally, this shouldn’t be the case, and when this occurs the market is communicating that it thinks near-term growth will fall, and that shorter-term yields should fall as well. Since mid-2022 the bond market has bet, so far incorrectly, that the economy would soften and that the Federal Reserve would begin lowering short-term rates.2
Since 1966, this indicator has produced no false positive readings. But we are now nearly 24 months from when the yield curve inverted3 and have had no recession.
As we’ve noted before, many signals are not very reliable as they often produce false positive readings. Popular (and ominous sounding) indicators like the Death Cross or Hindenburg Omen are good examples of this.4 The inverted yield curve has been much more reliable in the U.S., although it has had some misfires.
Back in late 2018, the curve inverted largely due to the Federal Reserve hiking rates, similar to the current situation.5 The U.S. actually didn’t tip over into recession until the COVID-19 lockdowns in 2020.6 And outside the U.S. the inverted yield curve has not been a reliable predictor at all.
One reason why we have now had the longest stretch between an inversion and a recession is extreme policy shifts. Signals have been particularly noisy with interest rates moving to zero then rising faster than any time in Fed history. Add in record spending and deficits (occurring during an expansion) and we have unique circumstances that are creating noisy signals.
In sum, the yield curve is communicating that growth will slow, which is one piece of information we are considering. But there is noise in markets (especially with recent policy shifts) and so signals like this shouldn’t be seen as a green light to make immediate and large shifts in a portfolio. We do think, on the whole, it is more likely that the economy at least slows from its pace in 2023. As investors, maintaining a disciplined approach that takes into account information but doesn’t make large commitments based on any one indicator is prudent. If you have any questions, please contact your Exencial advisor.
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