What Is an Inverted Yield Curve—And Does It Mean a Recession Is Coming?

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One of the main indictors of a recession coming in the United States is something called an inverted yield curve on treasury bonds. There are many kinds of treasury bonds ranging from one-month terms up to 30-year bond terms. The main indictor that experts follow—and time in and time out has been a great indictor—is the spread between the two-year bond and the 10-year bond. An inversion doesn’t mean that there will be a recession. However, every recession has followed an inversion since 1955.

What Is the Spread and What Does It Mean When It Inverts?

Well, a normal bond spread would mean that a bond maturing in two years should pay you less than a bond that is tying your money up for 10 years. This means that if I have a shorter window for my money to become available, I should have to give up some interest to get that benefit. An example of this would be: I can buy a two-year bond for 2.30 percent interest versus a 10-year bond paying 3.25 percent. This would be considered normal and not inverted. However, if the two-year treasury was paying 2.35 percent and the 10-year treasury was paying 2.30 percent, well that would signal an inverted yield curve and be a main point of conversation regarding a recession. Again, it doesn’t mean a recession is guaranteed, but it would not be inconceivable to have one sooner or later.

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Where Are We Now?

When rates rise, it creates an immediate fear of markets slowing and hence can put a drag on the stock market. However, a 25-basis point move by the Federal Reserve to increase rates is a slow increase and doesn’t mean stocks become less attractive right away. Today, the spread between the two-year and 10-year treasury is extremely close to inverting with a spread of only 0.02 percent. Again, this doesn’t mean that all of a sudden there will be a recession or a slowdown, but it is something to keep an eye on, along with other indictors, and should be monitored.

So, How Long Before a Recession, If the Bond Market Inverts?

Historically, a recession happens six months to two years following an inversion. Like I said earlier, an inversion doesn’t mean a recession will happen. It is simply an indicator that we could see one coming. Keep in mind we are in an unprecedented situation with high inflation, low rates, a Russian invasion of Ukraine and recovery from the pandemic. This makes things unique, for sure. Keep in mind that when rates go up, people tend to sell their short-term bonds for long-term bonds’ higher yields. That can help tighten the spread, as well as the long-term rates dropping, with bonds getting bought. The last time we had the bond market invert was in 2019, and we had an unexpected recession due to the pandemic. So, maybe we were do anyway?

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Time to Relax

First and foremost, the market tends to go up prior to a recession and rally. Also, this is simply an indicator, so there’s no reason to panic. A recession is actually healthy for the markets overall. Think about what a cold can do for your immune system in the human body; your immune system gets stronger and more resilient. The same thing goes for our financial markets. However, I would not expect one shortly, and I think the Fed is going really slow with their increases to help avoid a recession. Due to the pandemic, I wouldn’t be shocked either way—if there is or isn’t a recession. I also want to make clear that many of the other spreads on the yield curve signals an expansion in our markets. So, the bottom line is to stay the course in your long-term financial plan and goals—and hang on for an unpredictable time.

Evan Mayer is a financial advisor in Boca Raton, Fla., and the founder and CEO of Fortuna Wealth.

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