The yield curve can be a major economic indicator.  An inverted yield curve happens when short-term rates are higher than long-term rates.  This has been a somewhat reliable predictor of recession.

An inverted yield curve doesn’t make a lot of sense.  It means someone is willing to lend their money for a longer timeframe and get a lower rate of return.

If you can buy a 3-month Treasury bill at the same rate as a 30-year bond, why would anyone choose to buy the 30-year bond?  The only reason is that you expect rates might go down in the future and you want to lock in the return.

Of course, it is rare for an investor to actually buy a 30-year bond and hold it for the duration.  Most investors buy a bond fund.  Even if the fund includes longer-term bonds, the fund itself can get traded frequently.

It’s not exactly clear why an inverted yield curve is a predictor of recession.  Notice that I didn’t say it is a cause of recession.  We shouldn’t confuse cause and effect with correlation.

An inverted yield curve often means that short-term rates are higher because of a tight monetary policy from the central bank.  It can mean that entrepreneurs are taking out short-term loans (driving rates higher) in order to finish projects.  It can mean that investors are locking in long-term rates because they expect trouble ahead.  This obviously wouldn’t include trouble with price inflation, otherwise locking in your money for a long time with a fixed rate doesn’t make much sense.

2020

There was actually an inverted yield curve preceding 2020.  We got a recession in 2020, sort of, but it was short-lived.  We had government lockdowns, so it is hard to distinguish the lockdowns from any genuine recession.  The lockdowns themselves were worse than any regular recession.

Incidentally, the lockdowns did have one positive aspect economically.  People actually saved money.  Some people did it because they were scared.  Some people naturally saved money just because they couldn’t do things like go out to eat or go to a movie.

The Fed had already started to loosen its monetary policy in late 2019 and early 2020 because of the economic conditions.  But in March 2020, the base money supply absolutely exploded.  The Fed’s balance sheet went from just over $4 trillion in early 2020 to almost $9 trillion in 2022.  The initial explosion in March 2020 was nearly $3 trillion in the matter of 3 months.

This explosion in new money made whatever recession we had in 2020 very short.  It’s important to realize that this situation is very uncommon.  The virus and the lockdowns were an excuse for the Fed to go wild.

The Fed could technically do the same thing now in an attempt to avoid a recession or make it a really short one.  They could double the supply of money over the coming months.  But this is not likely to happen without a really bad economic downturn happening first.  Otherwise, the Fed risks destroying the dollar (more than it already has).

2020 was an anomaly.  We shouldn’t look at this and see that there was no bad recession after an inverted yield curve.

2023 and 2024 to Today

The yield curve was mostly inverted for all of 2023 and most of 2024.  This is a long time for it to be inverted.  This was coming off really bad price inflation that the Fed had to deal with.  Of course, it was the Fed that caused the price inflation because of its prior loose money, especially in 2020 as discussed above.

So, with the Fed hiking short-term rates in 2022 and investors not seemingly worried about sustained long-term price inflation, we got an inverted yield curve.

But the recession generally happens after an inverted yield curve goes back to normal.  There is a delay.  We are now in the phase of a normalizing yield curve.  It is still flat by usual standards.  The 30-year yield is only about 0.4% (40 basis points) higher than the 3-month yield.  The 10-year yield and the 3-month yield are almost the same.

All it will take is one more rate cut from the Fed to drive down short-term rates below the longer-term rates.

In other words, the recession could happen soon.

Trump’s tariffs have complicated things in a sense.  Trump will get blamed because of his tariffs.  If you want to blame the coming recession on Trump, you are better off looking back to 2020 when there were lockdowns and unprecedented spending out of Washington DC.  Someone had to fund the deficit, and that someone was the Federal Reserve.

Trump’s tariffs certainly make the economic conditions worse.  They could be the trigger for bringing on the recession faster because of the uncertainty they have caused for businesses.  But I believe we are getting a recession with or without new tariffs.

If History is Any Guide

The inverted yield curve is still a predictor of a recession.  There is no reason to think that “this time is different”.

You don’t even have to understand exactly how it works and why it predicts recessions.  Just know that it does.  And it doesn’t matter who is president or who is running the Federal Reserve.  The recession is already baked into the cake.

If the time duration and the intensity of the inverted yield curve is proportionate to the severity of the recession, then we are in for a doozy.  It was inverted for almost 2 years.

Meanwhile, the Fed is still engaging in a policy of slight monetary deflation (in spite of some previous rate cuts).  We have a recession coming and the Fed is actually still deflating.

Trump cannot turn this around simply by proclaiming that he has negotiated deals to reduce tariffs.  It just causes more volatility in the stock market.

Expect the volatility to continue, but expect stocks to fall a lot farther from here.