The yield curve has somewhat inverted in 2019. Comparing the 3-month yield to the 10-year yield, there was an inversion on March 22, 2019 that lasted about a week. It slightly inverted again on May 13, 2019.  As I write this, the two yields are essentially the same.

An inverted yield curve is a precursor to recession.  In fact, it is maybe the only thing we can look at with reliability, as it hasn’t signaled a false positive, at least up until this point.  A recession will follow an inverted yield curve typically within 2 years or less.  The timing part is hard to get right.

As with so many things in economics, it is important to understand cause and effect.  An inverted yield curve is not causing a recession.  It is a warning for a recession.  Bond investors are buying more long-term government debt, thus pushing interest rates lower on that long-term debt.

Why would an investor buy a 10-year Treasury bond with a 2.4% yield when the investor could buy a 3-month or shorter Treasury bill for the same 2.4%?  After all, you are locking up your money for 10 years if you don’t sell the bond.

The reason is because the investor expects rates to go even lower in the future, which would drive the price of the bond higher.  He would rather lock in a rate at 2.4% and also lock up his money for 10 years rather than buy the short-term debt.  If we hit a recession, the yield on the short-term debt could go way down from 2.4%.  It could go to close to zero.  In our bizarre world of finance today, it could even go negative.  That is why an investor would want to lock in a rate for 10 years.  It is due to fear of lower rates in the future.

The bond market is the smart money, at least compared to the stock market.  This is a generality.  There are always buyers and sellers on both sides.  It’s just a question of what the latest price is, or what is happening on the margin.

The Fall of 2008

It is interesting to go back to 2006 to look at the yield curve.  The 10-year yield fell below the 3-month yield in February 2006.  In that same month, the 30-year yield actually fell before the 3-month yield. They were only briefly inverted and then went back to “normal” in March 2006.  The yields inverted again for much of 2006 and part of 2007.

But it is important to note that the official recession began in December 2007.  By that time, the yield curve was no longer inverted, as short-term rates had already started to fall quite a bit.

The financial crisis became evident in September 2008.  This is when it looked like financial Armageddon.  But this is just when things came to a head.  The problems were already there.  The housing bust had already started, and the recession had already started even if not everyone was aware of it yet.

Again, this just shows that the timing is impossible to predict.  But the inverted yield curve was quite accurate in predicting the recession of 2008, which technically started in 2007.

The 30-year yield inversion is even more dramatic than the 10-year yield.  Different people use different measures, but I don’t think that having the 30-year yield drop below the 3-month yield is a necessity for a recession.  It may or may not happen this time, although I suspect it will eventually invert.

The 10-Year Yield vs. the 30-Year Yield

The reason I don’t fully subscribe to just watching the 30-year yield is because it is just too far out there.  We have no idea what anything is going to look like in 20 or 30 years.  If you see a deep recession on the horizon, it doesn’t necessarily make sense to lock your money up for 30 years unless you think you can easily sell the bond at a much lower interest rate. Most of us don’t expect a Japan-like scenario where interest rates are low for decades.

If you think there will be a deep recession over the next few years followed by a period of higher price inflation, then a 30-year bond wouldn’t make sense.  Interest rates will go up once there is fear of price inflation.  Just look at what happened to interest rates in the 1970s.  Short-term and long-term rates went into double digits due to price inflation.

If a recession hit, then it is almost a guarantee at this point that the Fed will buy more U.S. government debt.  This would tend to drive rates down further.  But if the Fed creates so much monetary inflation that it turns into fear of expected higher price inflation, then this could ultimately drive interest rates higher.  It would likely take a little time for this to play out, but you can see why an investor might not want to buy a 30-year bond, even if the Fed is initially buying up debt.

For this reason, I don’t think the really long-term debt yields have to drop below the short-term yields to guarantee a recession.  For me, the drop in the 10-year yield is enough.  Bond investors are telling us that they would rather lock in this seemingly low rate for 10 years because they think it is headed lower. We should listen to the smart money and take this warning seriously.