Conventional wisdom is that an inversion of the yield curve (short-term interest rates moving above long-term interest rates) signals that a recession is coming, but this is only true to the extent that a recession is always coming. A reversal in the yield curve from flattening to steepening is a far more useful signal.
What a yield curve inversion actually means is that the interest-rate situation has become extreme, but there is no telling how extreme it will become before the eventual breaking point is reached. Furthermore, although there was a yield-curve inversion prior to at least the past seven US recessions, Japan’s most recent recessions were not preceded by inverted yield curves and there is no guarantee that short-term interest rates will rise by enough relative to long-term interest rates to cause the yield curve to become inverted prior to the next US recession. In fact, a good argument can be made that due to the extraordinary monetary policy of the past several years the start of the next US recession will NOT be preceded by a yield curve inversion.
Previous US yield curve inversions have happened up to 18 months prior to the start of a recession, and as mentioned above it’s possible that there will be no yield curve inversion before the next recession. Therefore, we wouldn’t want to be depending on a yield curve inversion for a timely warning about the next recession or financial crisis. However, the yield curve can provide us with a much better, albeit still imperfect, recession/crisis warning in the form of a confirmed trend reversal from flattening to steepening. This was discussed in numerous TSI commentaries over the years and was also covered in a blog post last December.