Winter is Coming: the Inverted Yield Curve & the next Recession

Ben Le Fort
Apr 2 · 4 min read
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The fact that everyone is freaking out about the possibility of a recession increases the chances we actually get one.

Inverted Yield Curve

You may have seen a lot of coverage in the media about the yield curve “inverting” and how that is an indicator for an upcoming recession. I think it’s useful to start by answering a few basic questions.

  1. What is the yield curve?
  2. Why are people worried about an “inverted” yield curve?

The yield curve is simply a chart that shows the interest rates (the yield), of with different maturity dates. Here is what a “normal” yield curve looks like.

The Normal Yield curve has an upward slope, indicating the longer time to maturity, the greater the yield.

The “normal” yield curve has an upward slope. This indicates that bonds with a longer maturity date will have a higher yield. For example, a bond that matures in 5 years would pay a higher interest rate than a bond that matures in 1 year.

A normal yield curve indicates that people expect the economy to be performing well in the future. If people believe the yield (interest rate) of bonds will be higher in the future than it is today, that is because they expect central banks to raise interest rates in the future. Which typically happens in response to a “hot” economy. Higher interest rates are used to respond to inflationary pressures caused by a hot economy. So if we think that yields will be higher in the future, we may also think the economy is set to expand.

The “inverted” yield curve has a downward slope. This indicates that bonds with a longer maturity date will have a lower yield. For example, a bond that matures in 5 years would pay a lower interest rate than a bond that matures in 1 year.

This is what an “inverted” yield curve looks like

The inverted yield curve is downward sloping indicating bonds with longer maturity dates pay less interest.

An “inverted” yield curve indicates that a recession may be on the horizon.

A downward sloping yield curve indicates people think that interest rates (and thus bond yields) will be lower in the future than they currently are.

If the market believes that interest rates are going to be cut in the future, that means that they believe the economy will not be performing as well as it is today. The primary reason interest rates would be cut would be to encourage economic growth or to pull the economy out of recession.

The Yield Curve’s History of Predicting Recessions

The yield curve inverted between 6 months to 2 years prior to the 1981,1991, 2001 and 2008 recessions. This historical precedence matches up with the theory behind an inverted yield curve. This has created widespread adoption of the idea that an inverted yield curve is a clear sign that a recession will be coming sometime in the next 2-years.

I say “widespread” rather than universal belief in the yield curve’s predictive powers because there are some who do not believe the dynamics in the debt market are the same today as they have been in the past.

There has been a substantial increase in the demand for U.S treasury bonds which have 10–30-year maturity dates. These bonds are in high demand because they are viewed as one of the safest investments due to the low likelihood of the U.S defaulting (not paying) on its debt.

Some look at the recent inversion of the yield curve as a function of supply and demand rather than an indicator of an upcoming recession. If the demand for a product increases the supplier of the product can offer it at a more favorable price.

If the demand for long term bonds increases, the supplier of those bonds can find buyers without offering a high-interest rate.

Whether the yield curve truly has predictive power or not is almost irrelevant. What truly matters is if enough people believe an inverted yield curve means a recession is coming.

If the expectation is that a recession is coming, that can cause households and businesses to reduce consumption and investment, which can lead to a recession.

The fact that everyone is freaking out about the possibility of a recession increases the chances we actually get one.

Impact Economics

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Ben Le Fort

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Sharing my journey to financial independence. For freelance inquiries reach me at benlefort1988@gmail.com

Impact Economics

Our Goal is to Make Economics Understandable and Relevent