EC Was The Recent Yield Curve Inversion A False Alarm?

Fears of a recession have increased in the wake of the brief, modest yield curve inversion in March. It is true that the last six US recessions were preceded by an inversion of the Treasury yield curve. This happens when short-term rates rise above those of longer-dated bonds.

On March 22, the yield on the benchmark 10-year Treasury note fell to 2.42%, dropping below the rate on three-month T-bills, marking the first yield curve inversion since July 2007. The logical conclusion is that if a recession followed the past six inversions, the next one must be on the way.

That’s not a fact, rather, it’s a belief that has permeated the investment community, with many market commentators citing prior inversions to confirm their conclusion that a recession must be just around the corner. Yet there are no obvious signs that we’re headed for a recession later this year or early next year.

Maybe we should look at the recent brief, modest yield curve inversion as compared to prior inversions, and more importantly, what caused it to occur. There are some key differences – including whether the inversion was caused by rising front-end (short-term) rates or by falling back-end (long-term) rates.

We can see in the chart below that the yield curve inverted prior to each of the last six recessions. Most of those inversions occurred because the Fed rapidly tightened monetary policy (raised rates) to fight inflation and counter previous policy that might have been too stimulative for too long. This caused front-end rates to rise well above inflation, making money expensive.

When money becomes very expensive, it causes a drop in economic activity and a recession follows, typically about a year later. Some economists call this a “bear inversion.”

(Click on image to enlarge)

But this time around, rather than an aggressive Fed raising rates to curtail inflation (inflation remains quite low), the brief, modest inversion has been reversed by the latest return of a dovish and accommodative central bank. This has led to yields on longer-dated bonds dropping more. Some forecasters call this a “bull inversion.”

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