Any way you look at it, the US yield curve is flattening:
- The spread between 30-year and 10-year yields has moved down to 0.18%, the narrowest since July 2007.
- The spread between 10-year and 5-year yields has moved down to 0.14%, also the narrowest since July 2007.
- The spread between 10-year and 2-year yields has moved down to 0.41%, the narrowest since September 2007.
When I post these charts on twitter, nearly all of the responses are bearish (“here we go again”). People remember the last recession and the inverted yield curve that preceded it.
On its face, concern about an inverted curve does not seem unwarranted. The last 9 recessions in the US were all preceded by inversion, with 1-year Treasury yields rising above 10-year yields.
Data Sources for all tables herein: NBER, FRED. Using monthly data.
What is less known than this fact is the lag between the first inversion of the curve and the start of the actual recession – 14 months on average. In the last cycle, the yield curve first inverted in January 2006 and the recession did not start until 23 months later, in December 2007. It can take some time for weakness to occur, which is what you should expect from a leading indicator.
So is inversion a real risk today?
Looking at the spread between 10-year and 1-year yields, it doesn’t appear to be. At 0.66%, we are still quite a bit away from inversion.
Does that mean there’s zero risk of recession here? Unfortunately, no. While recession risk may be low today, there’s no rule that states an inversion is a necessary precondition.
For many years an inverted curve was nearly impossible, as the Fed was holding short-term rates close to 0%. After 6 rate hikes (1 in 2015, 1 in 2016, 3 in 2017, 1 in 2018), that backdrop is slowly changing. I say slowly because the economic expansion will hit 9 years in June (2nd longest in history) and the Fed Funds rate will still be below 2%. We’ve never seen an inverted curve or the start of a recession with the Fed Funds rate that low.
However, if the Fed makes good on their projection to hike 2 more times this year and 3 times in 2019, it would bring the Fed Funds rate up to around 2.875%. That would be just shy of the lowest level we’ve seen at a prior inversion, 2.94% in 1956.
Does it have to get to that point before an inversion/recession? No.
In terms of Fed policy, everything about this cycle has been different than prior cycles so there’s no reason to expect what happens next to be the same. We could see an inversion at a lower interest rate level, a shorter lead time after inversion, or perhaps no inversion at all. When it comes to markets and the economy, the “rules” are always changing.