Upward sloping, good. Got it. What does an inversion represent then?
An inversion flips the normal yield profile, meaning short-term bonds pay a higher yield than long-term.
That sounds like a change in perceived risk.
Exactly! The inversion captures the fear of a downturn on the horizon.
I’ve heard people say an inversion causes a recession but that simply isn’t the case, is it?
Nope. The inversion is a symptom rather than a cause. If you take a step back, the yield curve is just a gauge of investor sentiment. Faltering confidence can certainly impact economic growth, but the inversion itself doesn’t cause a recession.
What has inverted so far and what’s left?
The first relationship to invert was the 5 year-3 year in early-December and was followed by the 5 year-2 year a day later. The 10 year-2 year curve, which is the preferred leading indicator, has yet to invert.
But that could change quickly, right?
Yes, it could. Historically we have seen the 10 year-2 year lag the shorter-term yields by about a month and the difference between the two yields is at the lowest level since the mid-2000s. This tells us an inversion over the next 30 to 60 days is likely.
Final question: recession yay or nay?
Once the 10 year-2 year inverts we have historically seen a recession begin within 6-24 months, knowing 6 months is an outlier. Looking at today’s economy, I can’t say it doesn’t indicate a recession is forming, but there are some things that suggest ‘this time is different.’ Quantitative easing in other parts of the world has put downward pressure on foreign bonds, including Japan, the UK, and Germany. For investors seeking a higher yield, this makes the 10-year Treasury a more attractive alternative, which puts downward pressure on the US 10-year note. Furthermore, we haven’t seen the pickup in inflation that typically corresponds with a strong economy, which has also kept the longer-term yields lower*. These atypical pressures on the 10-year make the relationship between an inverted yield curve and recession less certain than in the past, but every expansion has had an excuse for why it is unique.
It seems clear that we will be ringing in 2019 with a new layer of uncertainty, but our team is here to help.
Note: Data last updated end of day December 6, 2018.