Inverted Yield Curve Signals Imminent Recession

Chris Dios - August 14, 2019


Inverted Yield Curve Signals Imminent Economic Downturn

The yield on the 2-year United States Treasury note surpassed that of the 10-year United States Treasury note for the first time in over ten years on Wednesday morning, officially inverting the yield curve. An inverted yield curve is one of the strongest and most accurate indicators that a recession is on the horizon.

The 10-year T-Note yield fell to 1.58% on today, one basis point less than 2-year T-Note yields at 1.59%. Long-term bonds typically yield more than short-term bonds, so a yield curve inversion is atypical of normal market conditions.

Inverted yield curves predict recessions with uncanny accuracy and usually signal a downturn 13 to 17 months in advance. Once, in the mid-1960s, the inverted curve sent a false signal. In this instance, the economy slowed following the inversion but the slowdown didn’t technically qualify as a recession. Outside of that occurrence, the yield curve correctly predicted all nine U.S. recessions since 1955.

It’s the strongest signal yet that a recession is coming. Part of the yield curve inverted in March when the 3-month yield topped the 10-year yield. However, as a recession indicator, an inversion specifically occurs between the 10-year and 2-year bond yields.

Inverted Yield Curve: How to Play It

If the yield curve inversion is correctly predicting a recession, history tells us that there is still time. An inversion typically occurs more than a year in advance of an actual recession so, even if it ends up being correct, there is still time to get some gains out of the market.

Some analysts point out that the S&P 500 tends to mount a last-gasp rally before sliding into recession. On average, the rally peaks approximately 7.3 months after the 10-year and 2-year bond yields invert.

At this point, the inversion is minuscule. Only one basis-point separates the two bond yields, so the trend could easily reverse if the market takes a turn. It’s not time to panic just yet, but be aware of the yield curve inversion and its effects on markets.

Psychologically, an inverted yield curve spreads bearish sentiment and potentially adds momentum to downside moves. However, interest rates and tariffs are still the biggest influencers on the market. A trade deal with China could easily accelerate yields in the opposite direction, and the Federal Reserve can also intervene to normalize yields.

Don’t give up on the market just yet. An inverted yield curve is symptomatic of a problem in the market, but it doesn’t necessarily cause a recession. History isn’t always an accurate benchmark for predicting today’s market. The market is a very different place today than it was during prior yield curve inversions, so it could have a totally different reaction to the event.

Don’t be afraid of an inverted yield curve, but be aware of it. As long as you’re making smart trades with sound strategy, there’s nothing to fear.

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Chris Dios is an American writer and entrepreneur based in the Greater NYC area.

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