On Wednesday, 10-year Treasury yields fell below the rate on 2-year notes for the first time since 2007. The so-called yield curve inversion sent ripples through financial markets, spurring a near 3% drop in the S&P 500 while safe-haven currencies surged. “#TrumpRecession” was trending on Twitter. The reason for alarm? Sustained inversions of the yield curve, especially the difference between three-month bills and 10-year bonds, have preceded every recession since at least the 1960s.
Longer-maturity bonds tend to have a higher yield than shorter-term assets, as investors typically demand more compensation to tie up their cash for longer periods and to offset the effects of inflation. It’s a sign of optimism in the economy: Strong growth is expected to generate price pressure. But a flatter curve indicates that markets are bracing for sluggish growth ahead, and the curve between 3-month and 10-year yields has inverted before each of the past seven U.S. recessions.
Despite its strong track record, whether an inverted yield curve is still a reliable predictor of a U.S. downturn is up for debate after a decade of extraordinary central bank stimulus.
When the 10-year yield first fell beneath the three-month yield in March, many economists and investors weren’t ready to sound the alarm. Previous inversion-recession links have come after sustained periods of yield curve inversions, rather than a brief episode. For instance, the portion of the yield curve that turned negative for a couple days in 1998 bounced back until a more pronounced inversion began in July 2000. But after the short-lived bout in March of this year, the 3-month versus 10-year curve inverted again in May and has stayed that way for most of the summer.
Even so, just because yield curve inversions have preceded recessions in the past doesn’t necessarily mean this one will predict a recession in the future.
“I would really urge that on this occasion it may be a less good signal,” said former Federal Reserve chair Janet Yellen on Fox Business Network’s WSJ at Large with Gerry Baker on Wednesday. “The reason for that is that there are a number of factors other than market’s expectations about the future path of interest rates that are pushing down long-term yields.”
And long-term yields are certainly falling. This week the rate on the 30-year bond, the U.S.’s longest maturity, plunged to a fresh record low below 2%, or less than the Federal Reserve’s annual target for inflation.