How the yield curve predicts recessions
Inversion means the market expects rates, and therefore growth, to be lower later. It is a forecast made with money.
Read the market's own recession forecast, and know its limits.
How the yield curve predicts recessions works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
Normal, and inverted
Inversion means investors will lock in today's rate for a decade rather than roll short-term debt. They are betting rates, and therefore growth, will be lower later.
- 1
Normally, lending for longer pays more
Tie your money up for ten years and you take more risk than tying it up for two, so you demand more. Plot yield against maturity and the line slopes up. That is the healthy, boring, usual shape.
- 2
Inversion means the short end pays more
Occasionally two-year debt yields more than ten-year debt. That is odd, and it means something specific: investors are willing to lock in today's rate for a decade because they expect rates to be lower in future.
- 3
And rates fall when the economy is in trouble
Central banks cut rates in downturns. So an expectation of much lower rates is, in effect, an expectation of a downturn. The curve is not predicting a recession so much as revealing that a great deal of money is already betting on one.
It is a forecast, not a mechanism. The curve does not cause the recession, though tighter lending conditions that follow inversion may help.
- 4
The lag is the problem
Inversion has preceded recessions by anywhere from six months to two years. It is an excellent early warning and a hopeless timing signal, and people who sold on the first inversion have missed enormous rallies waiting to be proved right.
You can say what inversion reveals about expectations, and why it is useless for timing.
Read next
Inversion means the market expects rates, and therefore growth, to be lower later. It is a forecast made with money.
We screen for yield AND the balance sheet behind it, because the biggest yields belong to the companies least able to pay them.