The Yield Curve Inverted: Recession Incoming? A One-Year Update
About a year ago, Omar Khalil wrote this article on the inverted yield curve. If you haven’t read it, make sure to check it out! The inversions (plural) are now at multi-decade record levels, let’s see what the bond market is saying.
A negative 10-year-3-month yield spread predicted the last eight recessions, six to 15 months in advance, with zero false positives.
The inversion is currently very pronounced, at -1.79%, and has been negative since October 25th, implying a recession in the first quarter of 2024.
Coupled with banking failures, odds of a recession are increasing.
Keep in mind that the inverted yield curve is only one of many possible indicators and that it has only been tested on eight instances.
A primer on the yield curve
Banks and hedge funds spend millions building models that will tell them where the economy is headed. Luckily for you, the US yield curve has been a powerful recession predictor, and you can get it for FREE. Let’s understand the basics.
Like any other institution, the US government needs to fund its operations. It can do so by collecting taxes or by borrowing money. The way it borrows money is by issuing fixed-income instruments that are called treasury securities (because they are issued by the US Department of Treasury). Treasury securities are divided into three categories: (1) T-bills, which have maturities ranging from four to 52 weeks, (2) T-notes, which have maturities ranging from two to ten years and (3) T-bonds, which have maturities of up to 30 years. The main takeaway here is that investors can lend their money for different time periods of time, and they will also require distinct interest rates depending on how long they lend for. This is called the term structure of interest rates.
The yield curve is simply a graphical representation of said term structure. It’s a curve plotting the yields on US Treasury debt instruments with different maturities (bills, notes and bonds). It looks like this:
As you can see, the curve is supposed to be upward sloping: the longer the time to maturity, the higher the yield on the bond. Why? Because the longer an investor lends out, the higher the rate of return required. The reasons are rather intuitive:
more time before getting paid means a higher risk
as time progresses, inflation erodes purchasing power, so less can be bought for the same amount of money
there is an opportunity cost to lending money
people would rather consume today than in the future.
Taken together: time is money. The only way investors will lend for an extended period is by demanding a higher interest.
That being said, as the graph underneath shows, the yield curve can also be inverted. This version is downward sloping, so yields are higher for short-term securities than for long-term ones (at a certain point). This can happen if short-term interest rates rise more quickly than long-term ones or if the demand for long-term treasuries increases in anticipation of lower short-term rates.
Now that we know the basics let’s look at the yield curve today.
The yield curve today
Currently, the yield curve looks like this:
It’s clearly very inverted. Since US treasury yields are adjusted for constant maturity, we can compare them. The bills (short-term) are paying a higher yield than notes (medium-term) and bonds (long-term). For instance, the yield on the 3-month bill is 5.24%, whereas the yield on the 10-year note is 3.43%. You can click on this link (Link 2 below) to see how the curve looks at the time you’re reading (or how it looked at previous times).
A potential reason for this steep inversion is that the FED, which (indirectly*) controls the short end of the curve, is raising rates to curtail inflation. Meanwhile, the long end of the curve, which moves due to market participants, is not rising as quickly; perhaps because investors expect growth and inflation to be low in the long term.
*Note: the FED controls something called the Federal Funds Rate, which is the rate at which banks can lend excess reserves to each other overnight. This is not a treasury yield, but short term interest rates are correlated with moves in the Fed funds rate.
So, you know what a yield curve is and how it looks today. But you only care about one thing: is a recession incoming? Let’s analyse the curve.
2/10 vs 3/10 vs NTFS
In the first article, Omar highlighted that there are different ways to compare yields between long and short-term maturities. He discussed: 3-month vs 10-year yields, 2-year vs 10-year and the near-term forward spread. But which signal should we rely on?
The first spread to go negative was the 2-year vs 10-year one. By spread I mean the difference in yield between the 10-year note and the 2-year note; if it is negative, we have an inversion (2-year yield > 10-year yield). This is the inversion that prompted Omar to write his article in April of 2022. At the time, it had only been inverted for a few days. It has now been inverted since mid-July, so more than three quarters, and currently sits at -50 basis points.
The good news: this spread has had false positives, a negative 2y vs 10y spread doesn’t guarantee recession. The bad news: the 3-month vs 10-year spread is a better indicator, and the signal it’s sending is dire. As you can see on the graph, this spread has correctly predicted the last eight recessions with zero false positives. Check it out:
Source: Federal Reserve Bank of Saint Louis
The spread is currently far below zero, sitting at -181 basis points! This inversion started on the 25th of October, 2022, and completed the full quarter signal in January 2023. If history is any guide, recession is not a matter of if but when. Recessions have taken anywhere from six to 15 months (or two to six quarters) after this spread inverts to arrive.
Typically, a recession is defined as two consecutive quarters of GDP growth. In July 2022, the US GDP shrank for the second consecutive quarter, so one could argue a recession already took place. However, the labour market has not yet deteriorated, so the FED did not declare a recession. In fact, it was quick to dismiss these inversions because they have a preferred spread.
The FED prefers to look at something called the near-term forward spread (NTFS). The NTFS is the difference between the forward rate on bills 18 months from today and the current three-month treasury yield. The FED was not concerned about a recession because the NTFS was not inverted. The picture is very different today. The NTFS has now been in negative territory for more than a quarter. The effects are becoming more tangible, especially in the banking system.
Breaking the bank
Unless you’re using a homing pigeon for your news, you’ve heard of the collapse of the following banks: Silicon Valley, First Republic, Silvergate, Signature, and the buyout (more like bailout) of giant Credit Suisse. This yield curve inversion acts as a double whammy for the banking sector.
The first way in which the inverted yield curve broke the banks was by blowing up the balance sheet. On the asset side, it created large unrealized losses, specifically on long-term treasuries. Why? Simply because the market price of a bond varies inversely with interest rates. This creates duration risk, the risk that an increase in borrowing rates will make a bond less valuable. For example, if banks bought a bond at $100, higher interest rates could mean it's now worth $90. The loss on the bond is unrealised (think of buying a stock and watching it go down, but not selling, you haven’t taken the loss yet), and if they can hold it to maturity, then the treasury will pay back their principal and interest in full. In other words, the bonds have duration risk but not default risk. Silicon Valley Bank bought a large number of bonds at the start of the pandemic, hoping rates would go negative and they would resell at higher prices. Instead, interest rates rose at one of the quickest pace in history, creating $16 billion in unrealised losses, which the bank forgot to hedge. Hedging is like insuring a portfolio: investors buy instruments (typically derivatives) that are negatively correlated with the securities in the portfolio. In this case, one would have to buy instruments that mitigate the impact of changes in interest rates, like interest rate swaps.
On the liabilities side, customers notice that the US treasury is paying a risk-free four percent yield. Since deposits are earning them no interest, withdrawing the money, buying bonds and holding them to maturity is a lot more attractive. This deposit flight forces the bank to sell their bonds at a loss in order to raise new cash. The unrealised $16 billion loss materialises.
The second way in which the inverted yield curve broke the banks is by upending their business model. Banks operate through what is known as a carry trade, this is borrowing at low (short-term) rates and lending at high (long-term) rates. An inverted yield curve causes the opposite: borrowing at higher rates and lending at lower ones.
The bottom line
Omar pointed out in the first part of this series that “the recession risk increases substantially if:
The 3-month T-bill yield rises above the 10-year T-note and/or the 18-month T-bill yield.
The inversion of the yield curves stays inverted for a longer period.”
Both have already happened. The inversion is a signal that has predicted eight recessions with zero false positives. So based on this leading indicator, a recession is all but guaranteed. Coupled with recent bank failures, it is hard to argue that the signal is wrong. However, keep in mind that this is just one of many leading indicators, and it has only been tested over eight recessions.