There are a lot of treasury curves out there, but the one that historically has been most predictive of a coming recession is the 10-year 3-month treasury curve.
Before we get into this, let’s lay review a few key points about bonds.
- Bonds are priced based on various factors. The main ones are the bond’s initial yield, prevailing market interest rates (aka investor growth / inflation expectations), and the bond issuer’s credit quality.
- Bond prices and yields move inversely to one another. If the prevailing market interest rate rises, bonds with lower yields will be worth less. If the prevailing market interest rate falls, bonds with higher yields will be worth more.
- Generally, the longer timeframe of the bond, the higher the interest rate investors will demand to purchase that bond. That’s because if growth (and inflation) are expected to rise, the prevailing market interest rate will likely rise alongside them. And based on principle #2, that would make their bonds (and interest payments) worth less.
There’s much more to the bond market, but that’ll get you through the rest of this discussion.
What’s most important to know is that the yield curve helps isolate those factors by comparing two bonds of equal credit quality but different maturities. We use yield curves because they help us identify investors’ expectations about future growth.
Today, the 10-year 3-month treasury curve is “inverted,” which means that the 3-month treasury yield is higher than the 10-year treasury yield. ☝️
That tells us investors are not as optimistic about the economy’s future and think that interest rates will have to come down again to spur economic growth. As a result, they’d rather lock in a higher interest rate for longer. And since price and yields are inversely related, higher demand for longer-term bonds pushes yields down. And a lack of demand for short-term bonds pushes yields up. Hence, we get an inversion.
So why does this all matter? And how do we track it? 🤔
Economists track this yield inversion closely because it typically occurs several months or quarters before the economy officially enters a recession. As you can see from the FRED chart below, a prolonged inversion occurred before each of the official recessions over the last several decades.
It’s not a perfect indicator by any means. Each inversion varies in depth, length, and how long until a recession actually occurs. So using it as a market timing signal on its own is not an ideal strategy. But at the very least, it can let us know that we’re in an environment where the economy looks vulnerable. Especially when combined with other confirming factors.
And with the recent economic and earnings data, it’s unsurprising that many investors are adding this to their list of reasons to be concerned about the economy. 😨
Lastly, we’ll note that the yield curve briefly inverted a few weeks back. As a result, we’ll have to see if this inversion goes deeper and lasts longer, or is just another fake-out.
As always, we’ll keep you updated as things develop. Until then, happy spooky season. 🎃