Yield curve becomes inverted when short-term rates exceed long-term rates. An inverted yield curve occurs when long-term yields fall below short-term yields. Under unusual circumstances, investors will settle for lower yields associated with low-risk long term debt if they think the economy will enter a recession in the near future. Economist Campbell Harvey‘s 1986 dissertation showed that an inverted yield curve accurately forecasts U.S. recessions. An inverted curve has indicated a worsening economic situation in the future 7 times since 1970. The Federal Reserve Bank of New York regards it as a valuable forecasting tool in predicting recessions two to six quarters ahead.
In addition to potentially signalling an economic decline, inverted yield curves also imply that the market believes inflation will remain low. This is because, even if there is a recession, a low bond yield will still be offset by low inflation. However, technical factors, such as a flight to quality or global economic or currency situations, may cause an increase in demand for bonds on the long end of the yield curve, causing long-term rates to fall. Falling long-term rates in the presence of rising short-term rates is known as “Greenspan’s Conundrum”
The slope of the yield curve is one of the most powerful predictors of future economic growth, inflation, and recessions. One measure of the yield curve slope (i.e. the difference between 10-year Treasury bond rate and the 3-month Treasury bond rate) is included in the Financial Stress Index published by the St. Louis Fed. A different measure of the slope (i.e. the difference between 10-year Treasury bond rates and the federal funds rate) is incorporated into the Index of Leading Economic Indicators published by The Conference Board.
An inverted yield curve is often a harbinger of recession. A positively sloped yield curve is often a harbinger of inflationary growth. Work by Arturo Estrella and Tobias Adrian has established the predictive power of an inverted yield curve to signal a recession. Their models show that when the difference between short-term interest rates (they use 3-month T-bills) and long-term interest rates (10-year Treasury bonds) at the end of a federal reserve tightening cycle is negative or less than 93 basis points positive, a rise in unemployment usually occurs. The New York Fed publishes a monthly recession probability prediction derived from the yield curve and based on Estrella’s work.
All the recessions in the US since 1970 (up through 2018) have been preceded by an inverted yield curve (10-year vs 3-month). Over the same time frame, every occurrence of an inverted yield curve has been followed by recession as declared by the NBER business cycle dating committee. The yield curve became inverted in the first half of 2019, for the first time since – Wikipedia.
As inversion reaches deepest level since early 2007, some economists are sounding alarm bells about an imminent crash.
The three-month US Treasury bill rate became 32 basis points higher than the sinking 10-year yield – normally the greater of the two – and reached the widest difference since April 2007.