The Week: Yield Curve

The US yield curve has finally inverted. It’s spooked equity markets, but does it necessarily mean recession is imminent?


  • After many months of a flattening yield curve, it finally inverted this week
  • Typically, this has been an augur of recession and investors have taken fright
  • However, it may not have the predictive qualities investors believe

Well, it’s finally happened. The yield curve has been gently flattening for some time now, but finally, this week, it has inverted and with it, investors’ perception of the outlook for the global economy.

The problem, it seems, has become self-fulfilling. Investors are selling equities because the yield curve is flattening because historically, a flattening yield curve has been a predictor of weaker equity markets. Anyone spot a problem in that logic?

At its heart an inverted yield curve shows that bond investors expect interest rates to be lower in the long-term than they are the short-term. Interest rates would usually fall in response to a weaker economic environment. In this way, an inverted yield curve is thought to predict recession. 

The problem with it as a predictive tool is that there are a number of other reasons that long-term bonds can have a lower yield than short-term bonds. John Greenwood, chief economist at Invesco, points out that bond markets simply reflect supply and demand. Today, there is high demand for long-dated bonds – pension funds and other institutional investors require higher yields and this has pushed them into higher yielding long-dated bonds. In turn, this has created demand and pushed down yields. 

He believes that yield curve inversion only leads to recession when it comes from dramatic central bank tightening. This usually only happens when there are significant inflationary pressures. While inflation has ticked up slightly on the back of higher fuel prices, it still looks well-contained. 

Others have suggested that it is the front end of the curve that is anomalous rather than the long-end. Prices at the front-end – one year bonds – have been disrupted by central bank buying activity.

That said, economic growth is unquestionably slowing. Weak figures from the US, China and Germany have sent stock markets reeling over the past few days. However, most suggest that the chance of imminent recession remains negligible. 

Again, this is where flaws in the predictive power of the yield curve emerge. While the yield curve is generally seen to predict recession, the time frame is less clear. In fact, it may predict recession as much as 14 months early. That’s not all that useful. Stock markets can still move a long way in that time.

The inversion of the yield curve isn’t a good sign, but neither is it the automatic precursor to recession that many have suggested. It may signal tougher times ahead, but economic expansion could limp on for some time yet, in which case the recent volatility is no reason to panic.