A reliable recession indicator is flashing warning signs
One of the best-known recession indicators is flashing warning signs on the economy. Yields on longer-term U.S. government bonds are in danger of slipping below yields on short-term bonds, a relatively rare occurrence known as an "inversion."
Why it matters: Inverted yield curves can reflect a rising risk of economic recession. Analysts and investors closely watch for this early warning sign.
How it works: When the economy is healthy, yields — the interest rates investors are paid for buying government bonds — should be higher on longer-term bonds.
The intrigue: This year, short-term Treasury yields — which tend to be driven by expectations for the Federal Reserve's monetary policy moves — have shot higher, to 2.2% from about 0.75%.
- This reflects the Fed's move to choke off inflation by raising rates.
Meanwhile, yields on longer-term Treasuries — which tend to be more sensitive to the outlook for economic growth and inflation — have risen too, but a lot more slowly (to 2.4% from 1.5%).
- This reflects, in part, expectations that the war in Ukraine will hurt the world economy.
What's happening: The yield on the 10-year note is now only about a quarter percentage point higher than the two-year note, with many analysts expecting to see the 10-year fall below the two-year — an inversion! — sometime soon.
What they're saying: "If this continues, the risk is for an inverted yield curve," wrote Bank of America analysts in a note last week. "2s-10s inversions have preceded the last eight recessions and 10 out of the last 13 recessions."
Yes, but: Whether a recession follows could depend on whether the Fed continues to constrain the economy with rate hikes if and when an inversion occurs.
Flashback: When the yield curve began to approach inversion in 2018, it set off alarm bells about recession and helped trigger a near 20% drop in the stock market, as well as loud complaints from then-President Trump about the Fed's rate-hiking plans.
- In early January 2019, the central bank backed off the hiking plans and instead started chopping rates.
- The economy remained strong, and for a while, it seemed like the curse of the inverted yield curve had been broken.
The punchline: Then COVID arrived, and the U.S. suffered one of its most severe economic downturns on record. The predictive power of the yield curve lives on.
Go deeper: Fed's Powell bets on a buoyant economy