A Remarkably Accurate Warning Indicator For Economic & Market Peril

Would you have appreciated a single number that could have given you a clear and unmistakable warning before the tech stock bubble collapsed? How about an unequivocal mathematical warning in 2006 that major financial trouble was on the way, well before the problems of 2007 and 2008?

These warnings did exist and they can be seen in the gold areas of the graph above. They are called "yield curve inversions", and are quite uncommon, having occurred only three times in the last 35 years. The red areas show the three recessions of the last 35 years - and as can be readily seen, each yield curve inversion has been relatively quickly followed by a recession.

After languishing in obscurity for many years, "yield curve inversions" are back in the news again, because we just may be nearing another inversion.

In this nine-step analysis, we will review what yield curve inversions are, consider the potential for Fed rate increases leading to another inversion, explore the fundamentals of why inversions can be such an accurate early indicator of coming recessions, and look at the powerful information value for investors and investments.

This analysis is part of a series of related analyses, an overview of the rest of the series is linked here.

1. Definition

A yield curve is the relationship between interest rates and maturity at any point in time. The graph below shows the fairly normal yield curve just before the Federal Reserve began its cycle of increasing interest rates.

Interest rate yields are the vertical axis, the maturity of the bond or other fixed-income asset is the horizontal axis, and the overwhelming majority of the time, long-term interest rates are higher than short-term interest rates. This means that the slope of the line is positive, rising as we go from left to right (only the 1, 2, 5 and 10 year yields are actual market yields, the rest are interpolated between them).

Investors take greater price and inflation risk with long term bonds than short term investments, and they almost always demand extra yield in compensation for the extra risk.

The graph below shows something far less common, which is an inverted yield curve. In this case, it is from November of 2006, just over a year before the start of the Great Recession and the Financial Crisis of 2008.

Short term rates are higher than long term rates. The slope is now falling as we go from left to right, and this negative slope is referred to as an "inversion" in the yield curve.

Of course, there are an almost infinite number of possible shapes for yield curves and inverted yield curves. As a simplification measure, one commonly used market definition is to say that there is an inverted yield curve when the yield on 2 year U.S. Treasury notes exceeds the yield on 10 year U.S. Treasury bonds. Another commonly used measure is to compare the 3 month and 10 year yields, while others compare Fed Fund rates and 10 year yields.

2. History & Current Status

Every recession since 1975 - including the Financial Crisis of 2008 - has been preceded by an inverted yield curve (as defined by the 2 year Treasury having a higher yield than the 10 year Treasury).

The difference between the 2 year and 10 year Treasuries as of July 5, 2018, was 0.28%, which is the narrowest gap since August of 2007, shortly before the Financial Crisis.

In July of 2017, the average gap was 0.95%, which means the gap has narrowed by 0.67% in the last year. Should the relationship change by another 0.29%, we will have an "official" yield curve inversion. This could result from short term yields rising faster than long term yields, or long term yields falling faster than short term yields, or various combinations thereof.

3. Federal Reserve Interest Rate Increases

The Federal Reserve is currently in an increasing interest rate cycle as can be seen below, having raised interest rates by 1.75%% since 2015.

There is not a precise relationship between the Fed Funds rate, and 2 and 10 year Treasury yields. That said, the Federal Reserve's actions typically have a much more direct impact on short-term rates than long-term rates.

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Disclosure: This analysis contains the ideas and opinions of the author. It is a conceptual and educational exploration of financial and general economic principles. As with any ...

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Gary Anderson 10 months ago Contributor's comment

Interesting article. However, the Great Recession also contained the inversion of LIBOR with a fixed swap rate. That left banks helpless in the face of big swap payouts.

Alexis Renault 10 months ago Member's comment

Can you elaborate? That's the first I've head of it.

Gary Anderson 10 months ago Contributor's comment

Yes, Alexis, when the 3 month Swap rate exceeded the fixed 10 year swap rate, the inversion apparently was the straw that broke the camel's back causing the Great Recession. I wrote about it here with a chart: www.talkmarkets.com/.../the-federal-reserve-knew-libor-was-exploding-in-2007-and-did-nothing