Yield Curves & Recessions

What is the Yield Curve?

If you take the interest rate yields on U.S. Treasuries with maturities ranging from 3 months to 30 years and plot these rates, the resulting graph traditionally is an upwardly sloping curved line, with the yields on longer-term maturing bonds higher than on shorter-term maturing bonds.

Normal Yield Curves vs. Inverted Yield Curves

If yields were 2% on a 1-year bond; 2.5% on a 5-year bond; 3.0% on a 10-year bond; and 4.0% on a 30-year bond, this would be a “normal” upwardly sloping yield curve. On the other hand, image if these yields were the exact opposite, with the 1-year bond having the highest yield and the 30-year bond having the lowest yield. This would be abnormal, and the yield curve would be “inverted.”

It makes sense that yields on a longer-maturity bond would exceed those of a shorter-maturity bond, since you are taking more risk by investing in a longer-maturity bond.

Where Are We Today?

The yield on the 10-Year Treasury note dropped from 3.23% last November to 2.42% a week ago, putting it slightly less than the yield on the 3-Month Treasury bill and creating a small inversion. While yields could invert anywhere along the maturity spectrum, investors and economists typically focus on the 3-month vs. 10-year maturity. As of today, we are not inverted, as the 3-month yield is 2.43% and the 10-year is 2.49%.

What Does an Inversion Mean?

In an inversion, short-term yields exceed long-term yields, signaling worries about future economic weakness. The last seven U.S. recessions since 1965 were preceded by an inverted yield curve – so an inverted curve is not a good thing. However, there were two inversions during this period that were not followed by recessions. So, an inverted curve doesn’t always mean a recession is imminent.

Other Observations

An inversion needs to last for a while, such as a quarter, to provide a solid signal of the risk of economic weakness. An inversion that lasts a few days, such as the most recent one, is not very convincing.

Even when a prolonged inversion happens, it is a very impractical market timing tool. The number of months between yield curve inversion and a recession has averaged around 14 months but varied from a low of 8 months to a high of 24 months over the past 60 years. In addition, the time between an inversion and a peak in the stock market has ranged from 5 months to 21 months over that same period.

All that we can glean from today’s relatively flat yield curve or last week’s brief inversion is that investors, while watching a U.S. economy that is still expanding, have some worries about the slowing of the growth.

Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT is president of Townsend Asset Management Corp., a registered investment advisory firm located in Raleigh, North Carolina.  Email:   Gerald@AssetMgr.com