Trouble with the Curve

Historically, an inverted yield curve, specifically one in which the 2-year interest rate is higher than the 10-year interest rate, has been a signal that a recession is on the horizon.  As of this writing, the 2-year interest rate remains just below the 10-year rate.  Still, as Chart 1 shows, the yield curve has gone from substantially upward sloping to more or less flat.  In fact, the 2-year rate has recently risen above the 5-year rate, so the curve is inverted, though not with respect to the 2-year vs. 10-year rates, often noted as a recession signal.

The expectation of lower future interest rates is often a signal of a future recession because interest rates tend to decline when the economy enters a downturn.  The recent flattening of the yield curve could well be a move toward an inverted curve.  The 5-year rate is lower than the 2-year rate reflecting expectations of falling interest rates in the future, which may be a valid signal of a future recession, regardless of the level of the 10-year rate.

Is This Time Different?

But before we surrender to the power of the curve, consider some other facts.  First, while all recent recessions have followed an inverted curve, not all inverted curves have been followed by recessions.  Throughout 1966 the yield curve was inverted but a recession didn’t begin until 1970.  And in 1998, the yield curve briefly inverted but the economy continued to grow strongly for almost three more years.  So it is a good, but not perfect, predictor of a turn in the business cycle.

A second fact to consider is that one reason why the yield curve is so flat is because 10-year interest rates remain quite low, particularly given the current strength of the economy and gradual increases in the inflation rate.  One reason why long-term U.S. Treasury rates remain low is that the bond market is a global market and “low” U.S. rates are much higher than rates on 10-year German bonds (0.27 percent) or Japanese bonds (0.06 percent).  International investors have been buying U.S. Treasuries, keeping interest rates from increasing in the U.S.  Perhaps then the inversion of the U.S. yield curve is saying more about the outlook for global interest rates and growth than about conditions in the U.S.

Our View

Reflected in the forecasts we provide to the Philadelphia Federal Reserve, the economy is expected to slow substantially in 2019 and 2020.  Whether this slowdown results in a recession remains unclear, but in any case, an economy that grows only 0.5 percent is not much better than one that shrinks 0.5 percent.  Hopefully, any future inversion of the yield curve will be one of those “false positives” as in 1998.  But with the current expansion approaching a record 10-year length, it is probably best to be aware of the trouble with the curve.

For additional information or questions, please contact Mr. Peter Bernstein, RCF Vice President, 312-431-1540 ext. 1515 or by email:

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