Since June 2009, the U.S. has enjoyed the second longest period of expansion on record, benefitting from steady growth in a bull market. Despite the good times, experts warn that a recession is possible. Although headlining economic numbers like unemployment, GDP growth, and stock market returns have been relatively strong, several factors signal the risk of contraction in the near future.
The yield curve is essentially the difference between long- and short-term interest rates on U.S. government bonds. Historically, an inverted yield curve (when short-term yields move higher than long-term yields) has been a very reliable predictor of recessions and is closely monitored by policymakers.
The yield curve is a leading indicator of the business cycle, and the delay between an inversion of the curve and the beginning of a recession has ranged from six to 24 months. The inversion of the yield curve has correctly signaled all nine recessions since 1955 and has had only one false positive in the mid-1960s, when an inversion of the curve preceded an economic slowdown but not an official recession.
While historical circumstances differed for each recession, the patterns of past yield curve inversions are remarkably similar. A pronounced increase in short-term interest rates (which are essentially controlled by the Federal Reserve, or “the Fed”) generally drives the tightening of the curve. Long-term rates typically move much more gradually whether they increase or decrease. Long-term rates also reflect expectations of future economic conditions. While they increase with short-term rates in the early part of an expansion phase, they tend to stop when investors become pessimistic or fearful that a recession is nearing.
Below is a chart showing daily treasury rates in December 2018. The latter half of the month shows an inversion of the yield curve as the five-year yield drops below the six month- and one-year yields.
DAILY TREASURY YIELDS
12/1/2018 – 12/31/2018
Source: www.treasury.gov & Thomson Reuters
There are plenty of reasons to be confident in the current U.S. economy: unemployment is low, inflation is under control, and growth is strong. However, there is also a key indicator signaling that we’re nearing an end-of-cycle environment. Along with the yield curve flattening and inverting in places, trade wars, geopolitical issues, and government debt threaten to shock the system and could lead to an economic downturn.