What's Up With the Yield Curve? Is the US Economy Going to Experience a Recession?

The yield curve is a line that plots interest rates (yields) on bonds that have the same credit quality (financial solvency, or the ability for a firm or an individual to pay off debts) but different maturity dates (the day on which the final payment is due). There are two types of yield curves - normal and inverted.

In a normal yield curve, short-term debt instruments (in finance, debt instruments are tools used to raise capital) have a lower yield than long-term debt instruments with the same credit quality. Short-term debt instruments are due within a year's time (such as treasury bills) while long-term debt instruments are due after a year (such as long-term loans and mortgages). When the yield curve is normal, it is a sign of high economic activity. A normal yield curve signals that the economy is strong.

An inverted yield curve represents the opposite scenario, where short-term debt instruments have a higher yield than long-term debt instruments. In other words, individuals and firms have less time to pay off loans with higher interest rates. A yield curve usually reflects the investors' expectations for what they believe short-term interest rates set by the Fed will average over the lifetime of a bond (maybe even a little extra if risk-loving individuals hold the bonds slightly longer than they should). An inverted yield curve usually signals that a recession is about to come. A recession is when the GDP (Gross Domestic Product) declines for two quarters consecutively and the economy is unable to produce goods and services to its maximum potential. Inverted yield curves are a tell-tale sign of an upcoming recession because both investors and banks become more risk-averse. Investors have an incentive to take fewer risks and banks reduce the number of loans that they lend.

                                               

The 2-10 spread, which is the gap between yields on 10-year and 2-year treasury notes, is a common metric used to determine if a recession will come sometime in the future. When the 2-10 spread is negative, that is a sign that a recession may come in the future.

However, it is critical to understand that an inverted yield curve or a negative 2-10 spread doesn't mean that a recession is guaranteed. There have been times when the Fed has raised interest rates, lowered them, and managed to avoid a recession (like in 1996). This would have also happened after they cut interest rates in 2019 if the pandemic hadn't occurred. Furthermore, investors are optimistic because inflation has decreased despite the unemployment rate being at a nearly five-decade low (even taking into account the Fed's preferred inflation gauge, the core inflation index, which strips out volatile categories such as food and energy). Bond yields and Fed forecasts both suggest that real interest rates will gradually decrease and level off, meaning the economy won't experience a serious downturn. 

That being stated, we aren't out of the woods yet. While a normal yield curve is good, the yield curve usually uninverts right before a recession. Short-term bond yields fall because the Fed cuts interest rates. This phenomenon is known as "bull-steepening." Bond prices rally (increase) and yields begin to decrease, which causes the curve to get steeper and uninverted. But recently, the bond market instead experienced a "bear-steepening" because long-term yields increased significantly, while short-term ones increased only slightly. Although the yield curve was becoming less inverted, investors were growing more optimistic for the aforementioned reasons. Only time will tell what the economy will be like in the next couple of months and years. 

Sources:

Goldfarb, Sam. “Yield Curve Draws More Scrutiny.” WSJ, 14 Aug. 2023.

Hayes, Adam. “Yield Curve: What It Is and How to Use It.” Investopedia, Investopedia, www.investopedia.com/terms/y/yieldcurve.asp#:~:text=A%20normal%20yield%20curve%20shows,to%20periods%20of%20economic%20expansion. Accessed 17 Aug. 2023.