Is the Yield Curve Flashing Recession?

The yield curve is often considered one of the best leading indicators for the U.S. economy, which also makes it an insightful leading indicator for U.S. and global stocks.

It makes sense why the yield curve matters so much. Banks borrow money and pay deposits at rates on the short end of the yield curve (short-term interest rates), and then they in turn loan money to consumers, homeowners, and businesses at the long end of the curve (longer-term interest rates).

So, what happens when short-term interest rates are higher than long-term interest rates, i.e. when the yield curve inverts? The answer is that net interest margins get squeezed, profits fall, and a bank’s incentive to lend money falls. As banks loan less, economic activity tends to follow.

This explanation, of course, is a very distilled version of how the yield curve affects economic activity. But I believe it’s a useful way to frame your thinking.

History gives us hard evidence of how the yield curve plays into economic cycles, and it underscores the crucial importance of watching the yield curve as an economic cycle develops and matures. If we define the yield curve as the 10-year U.S. Treasury minus the 3-month U.S. Treasury, we can see in the graphic below that an inverted yield curve (when the blue line dips below the solid black line) has preceded a recession (grey bars) like clockwork.

We’re still not quite to ‚inversion‘ territory, though in my view, all signs point to the yield curve heading in that direction.

We at Zacks Investment Management expect the yield curve to continue flattening in 2019. The Federal Reserve has a key role in determining how quickly the yield curve could flatten, as they determine rates at the short end of the curve. Though recently the Fed has indicated a less hawkish approach to increasing rates, we would expect another rate increase or two in the offing perhaps later this year or early next.

Longer rates are a bit trickier to forecast, but I’d expect that modest long-term inflation expectations should keep long rates pretty subdued, and range-bound. I don’t really see a scenario where the 10-year U.S. Treasury goes much higher than 3% in 2019.

Taken together, the risk of an inverted yield curve in 2019 is high and rising, but not necessarily imminent. And even if it was, history suggests we’d have some time before a recession took hold. In short, it’s an indicator to watch perhaps more closely than any other, but it is not quite flashing recession.

So, instead of letting fears of a recession push you to make hasty investment decisions, I recommend staying focused on the long-term view, meaning focus on fundamentals instead of the daily price movements. To help you do this, I am offering all readers our Just-Released March 2019 Stock Market Outlook Report.