This Indicator Has Predicted Almost Every Recession. What’s It Telling Us Now?

The inverted yield curve. All recessions in the past fifty years were preceded by this phenomenon.  And, recently, the inverted yield curve has surfaced again.

What is an “inverted yield curve”?

First of all, the “yield curve” refers to the graph of the relationship between the maturity length of bonds and their yield.

In English…that means a normal yield curve resembles an upwards slope. That’s because investors should receive a higher interest rate to buy debt with longer maturities.

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It makes sense, right? A bond issuer should be willing to pay an investor MORE to hold  debt for a LONGER period of time. It’s the reason why the homeowners typically must pay a higher interest rate on a 30-year-mortgage than they would a 15-year-mortgage.

That’s the way a normal yield curve should work.

So, what what happens if macroeconomic imbalances cause the curve to flip?

It could signal danger for investors.

Historically, the inverted yield curve certainly has proven this out. Consider this:

  • The yield curve has inverted before each of the last five U.S. recessions so, at this point, it’s become a rather reliable indicator.

  • Additionally, if you look at the yield curve during this same period, the yield curve has ONLY inverted when there would soon be a recession.

  • Even more alarming (given the current curve) is that the inverted yield curve preceded these recessions about a year ahead of time.

For example, in the chart below, values below the line below show the points at which the 10-year treasury yields is less than the 3-year treasury yield–i.e. when the yield curve is inverted.

This chart might suggest that artificially low interest rates for too long a time actually does fuel speculative bubbles. These asset bubbles cause economic imbalances…that inevitably tend to lead to recessions.

The chilling reality is: we are now approaching one year (and a few months) after the appearance of an inverted yield curve. The U.S. yield curve inverted was at several points in 2019 and again, in February 2020. But, now…we have the Federal Reserve. And, the Federal Reserve’s uber aggressiveness might just be enough to rescue the curve and the economy.

Time will tell. Invest accordingly.

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