Almost All Recessions Began 6 to 24 Months After the Yield Curve Inverted

John Mauldin |


There was a little (at least short-term) good news recently if you’re worried about the yield curve inverting.

The 10-year US Treasury yield rose above 3% for the first time in four years. This will be the opposite of inversion, if it persists. It makes the curve steeper unless short-term rates rise even more.

In spite of that, the yield curve is still abnormally flat. The gap between 2-year and 10-year Treasury yields hasn’t been this low since before the last recession. This gap dropped below zero—i.e. inverted—shortly before the last three recessions.

We haven’t seen it yet in this cycle. But we certainly could see inversion within the next year or so if it keeps dropping at the current rate.

That’s quite possible if the Fed keeps hiking because they have hit their inflation and employment targets.

An Inverted Yield Curve Is a Far-Leading Indicator

The Fed is now walking a very tight rope. The Fed knows deep down that it has to get rates back up so that it has a few “bullets” for the next recession.

It is likely the Fed will keep hiking rates until we get to an inverted yield curve. Is the Fed aware of all the literature and what it’s doing? Absolutely. Candidly, I can’t imagine accepting a Fed appointment knowing that we are this late in the cycle.

Does an inverted yield curve guarantee a recession? No, but inversions are strong evidence that one is forming.

Last month, yet another new San Francisco Fed study found an inverted yield curve—which predicted all nine US recessions since 1955 and is still valid even in today’s low-rate environment.

However, yield curve inversion is a far-leading indicator, which is why my previous recession and bear market calls were early. Those nine recessions all began 6–24 months after the yield curve inverted.

And, in the ones I’m old enough to remember, many experts spent those months telling us that this time was different. (Spoiler: It wasn’t.) And I expect the same again.



Look around at all the great economic news. I’m aware of it. But the economy was hitting on all cylinders in early 2000 and late 2006, too. The numbers always look great right before a recession. Then it all rolls over at once.

A Sign That Something Is Rotten

An inverted yield curve doesn’t immediately damage the economy. It’s like fever. It points to damage that is already happening—an underlying infection.

It means bond investors have lost short-term confidence in the economy and want to lock in longer-term interest rates.

You don’t want to buy, say, one-year bills if you think rates will be lower when it’s time to reinvest them. That will be the case if, for instance, you expect the Fed to be lowering rates to stave off recession.

Fevers usually don’t kill you, they are a symptom of something being wrong. But if a fever gets high enough or lasts long enough, it will kill you. Which is why hospitals work so hard to keep your fever down.

A steeply inverted yield curve that goes on long enough is like having 108° fever. Both banks and shadow lenders go upside down on their “book” and stop making loans. That can freeze the economy and make a garden-variety recession even worse.

Which is why any central bank facing that scenario lowers rates and fights the yield curve.

The London Interbank Offering Rate (LIBOR) has for most of my adult life been the world’s most important private interest rate. By now, you know that it is going away and new substitutes are coming. But LIBOR is still out there for a short time, so let’s look at it.

There’s now less than a 60 basis point spread on the Treasury 2/10, and half that if you’re using LIBOR, which I think of as more free market.

If you go out the LIBOR swap market, you find a 20-year swap is not much different than a 10-year. The further out the curve you go, the flatter it gets. This is what happens at the end of an economic cycle and right before the yield curve inverts.

Get one of the world’s most widely read investment newsletters… free

Sharp macroeconomic analysis, big market calls, and shrewd predictions are all in a week’s work for visionary thinker and acclaimed financial expert John Mauldin. Since 2001, investors have turned to his Thoughts from the Frontline to be informed about what’s really going on in the economy. Join hundreds of thousands of readers, and get it free in your inbox every week.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Comments

Emerging Growth

Radient Technologies Inc.

Radient Technologies Inc is engaged in research, development and commercialization of environmentally responsible technology for the extraction, isolation and purification of soluble products from a wide range of materials using…

Private Markets

iPRO Network, LLC

We provide the platform, tools, and resources to empower individuals and professionals to market desirable goods and services to the public, taking the place of traditional methods of commerce.

Voleo

Voleo is a free download that allows you to form investment clubs with your friends, family, colleagues, classmates, teammates…basically anyone you know and trust. Invest and manage a stock portfolio…