Yield curve inversion has historically predicted U.S. recessions with greater accuracy than many other economic indicators. The signal has suggested a recession could be coming since summer 2022, but the U.S. economy continues to show robust growth so far.
What Is An Inverted Yield Curve?
An inverted yield curve occurs when long-term interest rates on U.S. government bonds fall below their short-term equivalents. For example, the 2-year interest rate currently is 4.5%, compared to 4.2% for the 10-year rate. Interest rates often rise as maturity lengthens but with an inverted yield curve, as we’re seeing now, the opposite is true. Inverted yield curves are common when the U.S. Federal Reserve has raised interest rates as the Fed has done recently to aggressively tame inflation.
Why It Matters
Researchers at the New York Federal Reserve have found that an inverted yield curve has historically been a good recession predictor going back to the 1950s.
As of January 2023, the New York Fed model gave a 60% chance of a U.S. recession on a 12-month view. However, that recession risk has been rising since 2022, and U.S. growth and job creation have remained strong in recent months, despite the dire forecasts.
Now, the yield curve is a leading indicator. So, a recession could still validate the forecast. But it’s also possible that the U.S. will avoid a recession despite the Fed raising interest rates — another unique feature of the current economic cycle.
Recent Strong Economic Data
A U.S. recession is formally defined by a panel of experts after the event happens. But a simple measure is two consecutive quarters of negative growth for the economy. That’s not what we’re seeing currently. U.S. growth has been elevated in Q3 of 2023 at 4.9% and still strong on the latest estimate for Q4 at 3.3%. January’s jobs report was also strong with 353,000 positions added, well above most expectations. As the U.S. economy continues to grow, the window for a 2024 recession narrows.
There are various theories as to why the yield curve may be less robust as an economic indicator than in the past. Some argue the U.S. economy is less dependent on interest rates than it once was. Others believe it might be another quirk of this relatively unique economic cycle. Nonetheless, the model holds that a recession is still more likely than not in 2024.
What’s Next?
From here, the Fed has hinted that interest rates are likely to fall. That could lower the recession signal, to the extent the yield curve becomes less inverted. However, there is still some way to go until then and the yield curve’s call for a recession remains in place.
There is still time for negative economic data to come in that could potentially cause a recession in 2024, as the yield curve predicts. Yet, so far, the economic news implies accelerating growth over recent months, rather than a recession.
That said, a lot more economic data for 2024 will come in. Others have argued that the best recession signal comes when the yield curve stops being inverted. So, it’s possible that the yield curve indicator may still be vindicated. But so far, in the current economic cycle, it is not forecasting as well as history suggests.
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