Can the Yield Curve Still Predict a Recession?

Nobody has a crystal ball, but for a long time, economists and market watchers have turned to the yield curve to predict when the next recession might strike. Lately, however, doubts about its accuracy have arisen.

What Is the Yield Curve?

The yield curve is a graph that shows the relationship between shorter and longer-dated U.S. Treasury yields. For example, it will show the yield of a 2-year Treasury note and a 10-year Treasury note. Traditionally, longer-dated debt should have a higher yield to compensate lenders for lending their money for a longer period. When the yield curve inverts, the opposite becomes true and shorter-dated yields rise above longer-dated ones, reflecting the higher risk to being a lender if the economy was going through a downturn in the short term.

Historically, an inverted yield curve has often accurately suggested that a recession may be on the horizon. But this seems to have changed. The yield curve was inverted from July 2022 until earlier this month – the longest stretch on record with no recession ever materializing.

In recent days, the yield curve has returned to normal, with the 2-year note yielding less than the 10-year note. But an “un-inversion” can also be considered an economic warning sign: If investors expect lower interest rates over the medium term, does that mean they were lowered (by the Federal Reserve) to stimulate an ailing economy?

Red Flag or Red Herring?

Clearly, the yield curve wants things to be just right. Alright, goldilocks. That’s why investors need context.

The yield curve may be more of a symptom than a diagnostic. Restrictive Fed policy for too long risks causing a recession, whilend the central bank will likely cut rates if it feels a downturn is imminent. The yield curve reflects this, but it also ignores the possibility of a soft landing, when the Fed manages its policy carefully to avoid a recession following a period of high interest rates. This has happened several times in the past, including in the 60s and 90s.

The central bank has maintained that a soft landing is the intended outcome of its current rate hike cycle, and some recent indicators suggest the economy is on a positive track. In that case, the yield curve’s recent behavior will still make sense — not as a predictor of a recession, but a side effect of the Fed’s successful maneuvering to avoid one.

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