Mar 23, 2022 - Economy

A reliable recession indicator is flashing warning signs

Yield gap on 2-year and 10-year Treasuries
Data: FactSet; Chart: Baidi Wang/Axios

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.

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