Insights + Resources

The Yield Curve as a Predictor of Recessions

Nov 23, 2022

Yield Curve Inversion Predicts Recessions 2-6 Quarters Ahead

The shape of the U.S. Treasury yield curve is often looked at as a barometer for U.S. economic growth. More specifically, it reflects how the Federal Reserve (Fed) intends to stimulate or slow economic growth by cutting or raising its policy rate. Each tenor on the curve is roughly the expected policy rate plus or minus a term premium (the term premium represents the expected compensation for lending for longer periods of time). In “normal” times, the yield curve is upward sloping, meaning longer maturity Treasury yields are higher than shorter maturity Treasury yields. However, when, like now, inflationary pressures are apparent and the Fed wants to slow aggregate demand, shorter maturity securities could eventually out-yield longer maturity securities, inverting the yield curve.

The predictive record of yield curve inversion depends on which parts of the yield curve are inverted. Two popular yield curve indexes are the differences between the 2-year Treasury yield and the 10-year Treasury yield (2Y/10Y) and the 3-month T-Bill and the 10-year Treasury yield (3M/10Y). Of these two, the 2Y/10Y is the most popular within the financial media (likely because it tends to invert before the 3M/10Y), but the predictive signal of the 3M/10Y has been more robust.

The past six times the 2Y/10Y part of the yield curve inverted, a recession followed, on average, 18 months later. However, the length of time between the quickest time to recession (6 months) and the longest time until recession (nearly 36 months!) complicates the signal and in the Fed’s words, the relationship is probably spurious. As such, we (and the Fed) tend to put more credence on the 3M/10Y, which has had a better track record in predicting recessions with a lead time of about four to six quarters, but as few as two quarters ahead.

View enlarged chart.

The 3M/10Y signal has predicted essentially every U.S. recession since 1950, with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967. There is also evidence that the predictive relationships exist in other countries, notably Germany, Canada, and the United Kingdom. Further, a signal that lasts only one day may be dismissed, but a signal that persists for a month or more should be looked at carefully. The current 3M/10Y inversion began in earnest in October, so using historical data as a guide and according to this quantitative metric, we’re likely at least two quarters away from recession. Finally, it’s also important to note that yield curve inversion does not provide much evidence in terms of length and/or magnitude of a potential recession. Over time, we’ve seen deep inversions with shallow recessions and shallow inversions with deep recessions. The signal only provides information on if a recession is likely over the next few quarters. We think any economic contraction will likely be a shallow one due to the continued strength of the consumer.

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IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.

Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC).

Insurance products are offered through LPL or its licensed affiliates.  To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.

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