The flattening of the yield curve points to a classic recession warning signal for the market. However, on its own, it merely warns us to expect a recession sometime in 2019 to 2024. The signal still provides useful information about where we are in the economic and market cycle and hence a guide to which assets and sectors have had historically the best prospects. So here's a quick summary about why it's true, why it's useless to time a recession and what it does tell us about the economic and market cycle.
What is a flattening and inversion of the yield curve?
A flattening yield curve is when the difference between (short term cash) interest rates and the long term interest rate yield from investing in bonds narrows. Interest rates represent the demand for loans and/or the central bank's desire to balance the economy to maintain growth and hold down inflation.
As the two rates converge and the yield curve flattens it says that investors are expecting a peak in interest rates. Finally when the yield curve inverts, current interest rates are higher than future interest rates, the implicit assumption is that interest rates are now so high that growth and inflation is likely to slow in the future and interest rates will therefore fall.
Does a yield curve inversion signal recession?
The answer is yes, it is a very good signal that recession is coming. The specific signal for the inversion of the yield curve is the comparison of yields from the two-year US treasury bond and the ten-year US Treasury bond. The two-year bond yield has risen above the yield on the ten-year ahead of all five recessions in the last forty years.
Why are the yields on the two-year and ten-year Treasuries chosen?
These are two historically well traded and recorded benchmarks for the Treasury market. The yield on the ten-year bond represents a good estimate of the long-term expectation of the interest rate trend. Two years is probably the longest horizon for attempts at economic forecasting, so the two-year bond yield reflects the current consensus on the direction of short-term interest rates. That means it gives the signal earlier than waiting for interest rates to rise above the ten-year bond yield. Liquid benchmarks and familiarity amongst investors makes these bonds a strong indicator of investor expectations, less likely to be distorted by other factors.
So when is a recession due?
Unfortunately, while the yield curve inversion has been historically accurate at predicting a recession, it is a poor timing signal. Recent history, the last forty years in the US, has seen a lag between signal and recession of one year to three years. Additionally we are not at inversion, the yield on the ten-year is 2.9% and the two-year has risen, even more sharply to 2.5%. That flattening to less than a 0.5% difference has historically led to an inversion, but again with a lag, of between a month and four years! Added together and we're left forecasting a recession in one to six years.