Does a yield curve inversion lead to a recession?
Investors remain uncertain as to whether the central bank will raise interest rates again this year after deciding last month to hold the Fed Funds rate steady. Economic projections continue to show the majority of Fed officials recommend one more rate increase. However, many investors now believe that no further increases are warranted. The basis for the no further rate increase is the run-up in long-term interest rates may be a substitute for further Fed rate hikes.
Economists continue to monitor various economic data, including the widely followed CPI numbers for September scheduled to be published tomorrow morning. However, the Federal Reserve continues to rely on one specific economic indicator - the spread or the difference in yield between the 10-year Treasury bond and the three-month Treasury bill to determine the probability of a U.S. recession taking place over the next 12 months. The track record of this indicator has been impressive, accurately calling U.S. recessions over the past fifty years. Another popular yield spread indicator favored by investors is the 10-year Treasury yields minus the 2-year yields.
Although the U.S. business and stock market cycles are not always in sync, history shows stocks tend to struggle during recessions. Studies also suggest the bulk of declines in stocks occurred after a recession has been declared, hinting that the New York Fed's favorite recession forecasting indicator can be useful for investors.
U.S. business cycles often show the Treasury yield curve sloping up to the right. Longer maturities (i.e., 10-year and 30-year Treasury yields) typically trade at higher yields than short maturities (i.e., 2-year, 1-year, 3-months, etc.) since investing in long-dated maturities should reward buyers with higher yields to compensate for duration risk.
The Treasury yield curve first inverted for the spreads between the 10-year minus 2-year yields (-0.06) in Apr 2022 and for the 10-year minus 3-mo yields (-0.04) in Oct 2022, as the yields of the shorter-term bills surpassed the longer-term Treasury bonds.
Yield-curve inversions hint that the economy is slowing or contracting enough to increase the risk of U.S. recessions. Although not every yield-curve inversion signals an official U.S. recession, all 12 recessions since WW II have been preceded by yield-curve inversions.
Based on the inversions of the spreads of the 10-year and three-month Treasury yields and the 10-year and 2-year Treasury yields, this increases the chance for a U.S. recession in the next 12 months.
Our long-term technical studies suggest the actual inversion of the U.S. Treasury yield curve does not necessarily signal an economic contraction or a major US recession.
When the spreads of the 10-year minus 3-month yield contract to an extreme low (negative spread) and then expand dramatically higher, this triggers a U.S. contraction/recession and an SPX bear market decline.
For instance, when the yield spreads traded to an extreme low of -0.95 (Jan 2000) before expanding sharply higher, this subsequently led to the tech/telecom 2000-2002 bear market.
Also, before the onset of the global financial crisis, yield spreads contracted to an extreme low of -0.64 (Feb 2007) before reversing and expanding sharply higher. The extreme widening led to the 2007-2009 global financial crisis and global recession.
Four years ago, the yield spreads again plummeted to an extreme low of -0.52% (Aug 2019) before rebounding from the 2007 bottom (-0.64). The spread would soon widen to 1.16 (Mar 2020), prompting the Feb-Mar 2020 pandemic-induced U.S. recession and the -35.41% SPX bear market decline from 2/19/20 to 3/23/20.
The spread would widen further to 2.27 (5/2022) before again contracting and falling into another yield inversion. The spread hit a bottom of -1.89 (May/Jun 2023) before expanding again. The current spread (-1.03) nears pivotal resistance at the 2001 bottom (-0.95) and the Mar/Oct 2023 highs (-0.83 to -0.81), suggesting another inflection. Above this extends the spread to -0.64/0.54 to -0.52 (Feb 2017 lows/Aug 2019 low, Dec 2022 high, and Aug 2019 lows). A breakout extends the spread from -0.30 to -0.23 (Nov 2022 breakdown, the 38.2% retracement from 2022-2023 decline, and 30-month ma).
However, failure to clear above -0.83 to -0.81 warns of a pullback to -1.36 to -1.24 (50-day and 200-day ma and Mar 2023 breakdown) and below -1.78 to -1.74 (6/26 and 7/19/23 lows) and -1.89 (May/Jun 2023 reaction lows).
In four previous yield spread expansions, three occurrences led to U.S. recessions and SPX bear declines (2000-2002, 2007-2009, and Feb-Mar 2020). However, the Jul 2012 2013 spread expansion resulted in neither a U.S recession nor an SPX bear decline. Note that an official yield curve inversion never developed before the 2012-2013 expansion in yield spreads. Will the current yield expansion lead to the former or the latter?