How Well Do Yield Curve Inversions Predict Recessions?

August 14, 2018


Just because the market thinks there might be a recession doesn't mean there actually is going to be a recession. So how good is it? Well, here's since the '80s and you can see there's three recessions plotted here. So the blue line is the 10-year Treasury. The red is the 3-month Treasury. And you can see in these circles is when it inverts. The red line goes above the blue line.

Now, how do I-- and then this is just showing it in terms of the spread. The spread goes negative here, here, and here in those same spots. Now, these gray bars, those are recessions. Those are when the actual recessions the U.S. economy hit and, boy, what do you notice about those red dots? They're right in front of those gray bars.

So these things invert and then, within a very short period of time, boom, the U.S. goes into a recession. So it looks like the market's pretty good at figuring this stuff out. Maybe they just got lucky the last three times. Nope. They're very good at this. The last seven recessions, the market ... the yield curve inverted. It was only in the 19-- what is that-- the 1950s then two recessions, and it didn't invert. Partly didn't invert because the thing was almost completely at zero or very low.

So it appears to be pretty good at predicting when these recession-- that's why we care about it. If this thing was 50-50, we'd say, maybe it's not really telling us much. The market's not that good at figuring things out. But at least in the U.S., man, this thing looks amazingly good. You can't find a better predictor of recessions.

The yield curve plots rates on similar assets with different maturities, such as the 10-year U.S. Treasury note and the three-month U.S. Treasury bill. Typically, the difference between the rates (also called the “term spread”) is positive, meaning longer-maturity assets have a higher return than shorter-maturity assets.

However, the yield curve can invert, meaning shorter-term assets have higher interest rates than longer-term assets. Many consider yield curve inversions to be a strong predictor of recessions.

In this video from a recent Dialogue with the Fed event, Director of Research Chris Waller reviews previous yield curve inversions and shows that they are indeed a strong predictor of recessions.

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