The macroeconomic climate of the past few years has been atypical to say the least. Pandemic-era stimulus programs contributed to the worst bout of inflation in four decades, and the Federal Reserve responded by raising interest rates at their fastest pace since the early 1980s. Many experts (including Fed policymakers) believe that macroeconomic roller coaster will culminate in a mild recession.
While predicting recessions is difficult at best, the U.S. Treasury yield curve has been a relatively reliable indicator in the past. Specifically, the three-month Treasury bill and the 10-year Treasury note have undergone a yield curve inversion before every recession since 1955, and that portion of the yield curve is once again inverted.
Here's what investors should know.
Image source: Getty Images.
What is a yield curve inversion
The U.S. Treasury yield curve is a graphical representation that plots the interest rate on short-term Treasury bills, medium-term Treasury notes, and long-term Treasury bonds. The curve normally slopes upward, meaning yields normally increase as time to maturity lengthens. For instance, a 10-year Treasury note usually bears a higher interest rate than a three-month Treasury bill. That happens because investors want greater compensation for taking on the additional risk that comes with longer maturities.
What risk? Forecasting inflation over the next three months is much easier than forecasting inflation over the next decade. That makes a 10-year Treasury note riskier than a three-month Treasury bill because the real return is more difficult to predict on longer maturities. For that reason, the 10-year Treasury note will generally have a higher yield to compensate for that risk.
However, portions of the yield curve occasionally become inverted, meaning shorter maturities pay more than longer maturities. That happens when demand for long-term Treasuries rises rapidly, indicating that investors expect yields to fall in the future, which itself signals a lack of confidence in the economy. In other words, investors believe that high interest rates in the present will ultimately hurt the economy, forcing the Federal Reserve to lower short-term interest rates in the future and thereby causing the yield on long-term Treasuries to fall.
What the current yield curve inversion means
Investors monitor the differential between many different Treasury yields, but the spread between the three-month Treasury and 10-year Treasury is watched with particular interest. That portion of the yield curve has inverted before each recession since 1955, meaning it has predicted the last 10 recessions.
That portion of the yield curve is once again inverted. The spread actually turned negative last October and it has since widened into the largest inversion in decades. This is shown in the chart below.
Data source: YCharts
As a caveat, although a yield curve inversion has indeed preceded the last 10 recessions, those recessions have taken as long as two years to materialize.
Why investors should stay invested (and keep investing)
That National Bureau of Economic Research defines a recession as a significant decline in economic activity that lasts more than a few months. Recessions typically coincide with a decline in consumer spending and business investments, and that often leads to weak growth (or even declines) in corporate profits. For that reason, investors may think it prudent to sell their stocks until the risk of a recession passes, but that strategy is inherently risky because it is impossible to time the market.
The S&P 500 actually started to rebound before economic activity reached a bottom during all but one recession in the last five decades. According to research from JPMorgan Chase, "In the median occurrence, the market rally began about four and a half months before [gross domestic product] found its low point and generated 30% upside in that period." In other words, investors who sat on the sidelines during past recessions probably missed out on big returns.
Here's the bottom line: The U.S. economy may be headed for a recession. The inverted Treasury yield curve certainly hints at that possibility. But investors should keep a few things in mind. First, past results never guarantee future performance, so the yield curve inversion could be a false alarm. Second, history says the stock market will probably recover before the next recession ends. And third, the S&P 500 has eventually recovered from every past recession, so investors should stay invested and keep investing.
