Inverted Yield Curve (Part 1) - Is a Recession an Inevitable Future? (2020, 2008, 2001)

What is the Inverted Yield Curve?

A yield curve is a line that plots the yields (interest rates) of bonds that have equal credit quality but different maturity dates. Typically, the yield curve slopes upward because long-term interest rates are higher than short-term rates in normal economic conditions. However, if future short-term interest rates are expected to be lower than current rates, the yield curve can slope downward. In this article, I will discuss the yield curves of the U.S. Treasury bonds.

Source: PGIM.com

Relationship between Inverted Yield Curve and Economic Recession

What is the relationship between a recession and an inverted yield curve? Let's look at a few news headlines on this topic.

As you can see, there is much debate about whether the inverted yield curve signals a recession or not. This is because past experiences of interest rate inversions have led to widespread acceptance of the notion that recessions follow inversions. And when discussing such commonly held beliefs based on experiences rather than mathematical laws, experts who claim "this time is different" inevitably emerge. So, will this time be really different? Let’s find out.

Yield curve inversions are often analyzed by comparing the 10-year U.S. Treasury bond yield with either the 2-year yield or the 3-month yield. While both methods are commonly used, I will focus on the latter, as it provides a more pronounced contrast between short-term and long-term interest rates. Besides, I am not trying here to explain the causal relationship or logical reasons between recessions and yield curve inversions. What should be interesting to investors is first verifying whether a recession has always followed an interest rate inversion, how long it took for a recession to follow an inversion, and whether there were any exceptions in the past.

Current U.S. Treasury Yield Curve

First, the graph below shows the U.S. Treasury yield curve as of August 26, 2024. The 1-month to 5-year segments are definitely inverted, and the 20-year to 30-year segment is slightly inverted as well.

Source: www.ustreasuryyieldcurve.com

The following graph shows the change in the "10-year US Treasury yield - 3-month US Treasury yield" from 1982 onward. 1982 is the earliest starting point for this data series provided by the Federal Reserve Bank of St. Louis. Gray vertical bars on the graph indicate recessions. There are five observed recessions during this period, which I will discuss in reverse-chronological order.

Source: fred.stlouisfed.org

(1) 2020 Recession and Inverted Yield Curve

Source: fred.stlouisfed.org

• Recession period: approx. 2 months (Feb 2020 - Mar 2020)
• Duration of inversion: approx. 4.7 months (May 23, 2019 - Oct 10, 2019)
• Time from inversion to recession: approx. 8.3 months
• Time from yield curve normalization to recession: approx. 3.7 months

The gray area represents the recession period. The 10y - 3m yield gap first turned negative on May 13, 2019, but this was resolved within 3 days. I have only considered cases where the inversion lasted for more than a week, excluding brief touches of below-zero. Recession dates are based on the National Bureau of Economic Research (NBER) criteria, which are announced monthly without specific dates.

The brief recession in early 2020 was due to the covid-19 pandemic. Could the interest rate inversion in May 2019 have predicted this unforeseen crisis? Of course not. Were the seeds of a recession already present in 2019, independent of covid-19? Maybe. In any case, the inversion was followed by a recession.

(2) 2008-2009 Recession and Inverted Yield Curve

Source: fred.stlouisfed.org

• Recession period: approx. 18 months (Dec 2007 - May 2009)
• Duration of inversion: approx. 10.4 months (July 19, 2006 - May 29, 2007)
• Time from inversion to recession: approx. 16.5 months
• Time from yield curve normalization to recession: approx. 6.1 months

Again, the inversion was followed by a recession. Compared to the brief 2019 recession, the 2007 recession was the most severe global financial crisis since the Great Depression, and the yield curve inversion period before it was significantly longer. The time from the resolution of the inversion to the recession was also longer. Let’s continue examining other instances.

(3) 2001 Recession and Inverted Yield Curve

Source: fred.stlouisfed.org

• Recession period: approx. 8 months (Mar 2001 - Oct 2001)
• Duration of inversion: approx. 6.5 months (July 7, 2000 - January 19, 2001)
• Time from inversion to recession: approx. 7.8 months
• Time from yield curve normalization to recession: approx. 1.3 months

Once again, the inversion was followed by a recession. Both the duration of the inversion and the recession period were moderate compared to those of the 2019 and 2008 cases. By the way, I will summarize the findings in a table for easier comparison once all yield curve inversion cases have been reviewed in a later post. I'll conclude Part 1 here and continue with Part 2 soon.

Thanks for reading. Wish you grow rich slowly and surely!

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