Recession Risk Indicator: Yield Curve or Inflation?

IN THIS PUBLICATION:

• A yield curve inversion is a poor timing tool for recessions and equity markets peaks.
• Every time we’ve had this level of inflation, the economy was about to enter or was already in a recession.
• Could the yield curve be underestimating today’s recession risk?

The US Yield Curve

Every recession over the last 40 years has been preceded by an inversion of the US yield curve (circled below). Therefore, when this portion of the yield curve approaches zero, alarm bells often start ringing, and media headlines about recession risk explode.

There are many yield curves to consider, but the most widely used ones tend to be the 5y10y and the 2y10y. The former has already inverted and the latter currently sits around 0.15% above zero (close to a potential inversion).

An inversion, however, is usually only the beginning of a lengthy countdown to a recession. Furthermore, whilst every recession has indeed been preceded by an inversion, not every inversion has preceded a recession (1997 – red arrow above).

The first instance of an inversion can take place from months to years in advance of a recession taking place. The sequencing is usually:

• The inversion begins, which is usually not particularly threatening to equity markets (1)
• The inversion continues until it reaches its maximum (lowest) point, which is generally when stock markets also peak, give or take (2)
• A re-steepening of the curve (2-Year Yields fall back below 10-Year yields), followed by a stock market sell-off (3)
• Somewhere between 6-9 months after, an economic recession begins (4)

An inversion is therefore a very poor timing tool for both recessionary events and peaks in the equity markets. And, as we all know, timing is incredibly important in the world of investing, as being “too early” is of no difference from being wrong.

Remember: the prelude to a recession since the early 1980s has not been the yield curve inversion (there were a couple of small inversions not followed by a recession), but rather the re-steepening of the curve after a yield curve inversion.