U.S. yield curve inversion: What is it telling us?

Fears of an imminent recession are somewhat overblown. These fears are showing up in fixed-income markets, where investors are betting that the risk of a recession is rising as the economy absorbs a supply shock in the commodity and energy markets and as central banks increase interest rates.

But economic fundamentals show that the probability of a recession over the next 12 months is roughly 20%, which is up modestly compared to before Russia’s invasion of Ukraine.

Once one accounts for the sharp moves in yields and the shape of the term spectrum, that probability jumps close to 35%, which denotes some risk but does not imply a sustained downturn consistent with what defines a recession.

Beyond these probabilities, a closer look at the different components of the yield curve reveals a more nuanced picture. The near-term forward spreads, or the three-month/18-month spread as well as the 10-year/three-month spread, both imply sustained growth compared to the inversion of the 10-year/two-year spread.

That is consistent with the strong labor market, solid consumer spending and businesses’ increase in productivity-enhancing investments despite rising inflation.

When using the shape of the yield curve as a method of forecasting, we are always careful to note that the 10-year/two-year spread has predicted 21 of the last 3 recessions.

One reason is that the structure of the economy has changed significantly over the past decade, so many of the old rules of thumb around identifying potential pivot points in the economy have changed as well.

It’s important for investors and managers to consider a range of alternative indicators when making decisions for investments and hiring.

Right now, those indicators are in flux and are implying different directions of growth in the American economy.

Everything about the end of the last business cycle and recovery has occurred in double time.

This includes the 2018 trade war and the subsequent global manufacturing recession, the economic shutdown of the pandemic, the economic reopening and the spread of the subsequent variants, the rise in workers leaving the labor force, the rapid discovery of vaccines, the breakdown of the supply chain, and, now, geopolitical conflict.

After the pandemic broke out, monetary authorities acted swiftly and avoided a worldwide economic collapse. And in its aftermath, they applied the appropriate caution for fear of damaging the sustainability of the recovery.

But only two years after the initial economic downturn, central banks find themselves fighting inflation while a war in Ukraine rages.

Already, financial market observers are worried that tighter monetary policy and the geopolitical risk premium have thrown a monkey wrench into the recovery and could send the economy into recession.