A closely followed recession indicator just flashed red for the 2nd time this year

A closely followed recession indicator just flashed red for the 2nd time this year

  • The yield curve on Thursday inverted for the second time this year as the 3-month yield climbed above the 10-year yield.
  • A yield-curve inversion has historically signaled a recession is coming in the medium-term.
  • Some economists, however, have argued this time may be different.
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A historical signal of a recession occurred Thursday, with the 3-month Treasury yield rising above the 10-year yield.

This market phenomenon is known as an inversion of the yield curve, and may have spooked markets which had already been under pressure following a breakdown in trade negotiations with China. The S&P 500 was down as much as 2% on Thursday before trimming its losses.

The yield curve usually slopes upward, as longer-dated Treasurys typically have higher yields than shorter-term ones. A flat curve means all Treasurys have the same interest rate, while an inverted curve means its sloping downward at some points, with longer-dated yields below shorter-dated ones.

The yield curve's inversion has caused concern among market commentators that a recession is near.


"Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve," wrote Michael D. Bauer and Thomas M. Mertens in a March 2018 Federal Reserve research paper. The lead time has varied however, sometimes taking up to three years, with the stock market often logging double-digit returns before the recession begins.

The 3-month and 10-year curve last inverted in March, sparking fears of a recession and a sell-off in the stock market. Before that, the last time such an event happened was in 2007, just months ahead of the Great Recession.

Investors usually receive higher interest rates when they commit funds over longer time periods. When the opposite happens, as it does during a yield-curve inversion, many people take it as a warning signaling near-term unease.

In contrast to this interpretation, some economists believe this time is different. Tom Porcelli, RBC's chief US economist, argues the inversions of 2018 (The 2-year 5-year curve inverted in December) and 2019 do not follow the historical pattern in which domestic investors drive down long-term rates over fears of short-term economic turbulence.

"The problem with the current inversion and the historical record is that the yield curve at present is not a referendum on the path of economic growth in the United States, but rather a function of goings on globally," he said.


"Yields have become more a function of global growth dynamics and indeed have become anchored to low/negative sovereign yields abroad."

Indeed, if this is the case, then a recession is not on the horizon as many others forecast. The robust US economy, which grew at 3.2% in the first quarter and has an unemployment at a 40-year low, will be further bolstered by low long-term rates.

"So, no, we are not on recession watch because of this dynamic - we are, more than any other point this cycle, on bubble watch," Porcelli concludes.

Still, in a recent blog post, Ray Dalio, co-founder of Bridgewater Associates, the world's largest hedge fund, predicted US long-term Treasury rates would fall close to zero as the economy weakens, making yield curve inversions more likely.

"It is inevitable that this shift will happen because it is inevitable that central bankers will want to ease when interest rates are pinned at 0% and when quantitative easing will be ineffective in achieving the goal," he wrote.