As investors digested both the Fed’s decision to raise interest rates by another 75 basis points and the news that U.S. economic growth declined in the second quarter, a significant yield curve inversion—perhaps the strongest harbinger yet of an impending recession—went largely unnoticed.
The yield on the two-year U.S. Treasury note now stands at 2.85% as of August 2–putting it 31 basis points higher than the yield on the 10-year U.S. Treasury note. Usually, of course, the longer-term security would carry a higher yield than its shorter-term cousin. When the yield curve inverts, that relationship gets turned upside down. One reason for such inversions is that shorter-term yields are more significantly impacted by Fed rate hikes than are longer-term yields.
More important, that inversion now stands at its most extreme point in decades: The spread between the 2-year and the 10-year yields is at a level not seen since the popping of the tech bubble back in the early ‘00s (see the chart).
The spread between these two yields is commonly seen as a reliable predictor of economic conditions. Consider:
- The yield curve has slipped to negative levels—inverted–an average of 15 months before the start of recessions since 1973.
- Of the four recessions we’ve seen since 1980, all of them were preceded by an inversion of the 2-year/10-year spread.
- Additionally, the Federal Reserve has increased interest rates before every recession since 1954.
All that said, the 2y/10y spread is just a single indicator—one that doesn’t have a perfect recession-predicting track record. There have been periods—1998, for example—where a recession did not occur following an inversion. There’s also the timing issue, as some recessions have started shortly after an inversion while others have taken up to 24 months.
The upshot: Making rash moves in the wake of an inverted yield curve isn’t a guaranteed recipe for successful goals-based investing outcomes. Moreover, investors may want to consider the upside potential for equities and other assets if a recession doesn’t come to pass.
This commentary is written by Horizon Investments’ asset management team.
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