Understanding the yield curve

The yield curve represents the difference between short-term and long-term government bond yields. 2-year and 10-year bonds are generally the most widely borrowed, but other horizons such as 5-year and 30-year can also be used. In general, long-term bonds offer higher yields to compensate for the additional risks associated with a longer investment period. This creates a rising yield curve in normal times. However, when investors anticipate a recession, they prefer long-term bonds, causing their yields to fall below those of short-term bonds, inverting the yield curve. This is what happened from July 2022 to September 2024, and yet there was no recession. In fact, since September, the 10-year has risen above the 2-year.

Why do inverted yield curves generally predict recessions?

The inversion of the yield curve is often interpreted as a sign of economic pessimism. When investors expect short-term interest rates to fall as a result of accommodative monetary policy to stimulate the economy, they turn to long-term bonds, driving down their yields. This anticipation of lower rates is often linked to expectations of an economic slowdown or recession. In other words, an inverted yield curve indicates that investors expect economic conditions to deteriorate, prompting central banks to cut rates to stimulate the economy. This expectation is often confirmed by a recession within 12 to 18 months of the yield curve inversion.

Historical data

Since the Second World War, every recession in the United States has been preceded by an inversion of the yield curve. For example, prior to the 2008 recession, the yield curve had inverted in 2006. Similarly, before the 2001 recession, the inversion took place in 2000. These examples show that the inversion of the yield curve is a generally reliable indicator of future recessions.

Source: Real Investment Advice & Isabelnet

Current debates

Despite its impressive track record, some economists are questioning the reliability of the yield curve as an indicator of recession in the current context. And until proven otherwise, they are right. The Federal Reserve's high policy rates, aimed at controlling inflation, are contributing to the current inversion of the yield curve.

Future prospects

While some experts believe that the current inversion of the yield curve may not signal an imminent recession - indeed, the 10-year has risen back above the 2-year and there has been no recession (yet) - others remain cautious. History shows that periods when people think "this time it's different" often end in recession. Investors and economists alike must therefore remain vigilant, keeping a close eye on economic developments and monetary policy decisions. The inversion of the yield curve remains a powerful and reliable indicator of economic recessions. While the current environment presents unique challenges, history teaches us that yield curve signals should not be ignored. Investors and policymakers must continue to monitor this key indicator to anticipate and mitigate the potential impacts of a future recession.