Historically, this curve—which occurs when short-term Treasury yields surpass those of long-term government bonds—has been a reliable precursor to economic downturns, accurately forecasting the past eight U.S. recessions without false signals. This time around things are radically different. Why?

Current Market Situation

Presently, the yield curve has been inverted for an unprecedented duration, spanning a whopping 22 months. Despite this, there are no clear signs of an impending recession. Last month, the U.S. economy added 175,000 jobs, and projections indicate an acceleration in economic growth this quarter. Consumer spending is robust and there is gainful employment.

This prolonged inversion without a corresponding recession challenges the yield curve's historical reliability as a textbook illustration for every aspiring MBA. If the economy refuses to sputter out, it will certainly undermine the yield curve's reputation as a dependable warning system. Some argue it is a paradigm shift reflecting broader changes in economic patterns following the Covid-19 pandemic, which have disrupted traditional market and economic functions.

Expert Opinions

Ed Hyman, Chairman of Evercore ISI, noted the discrepancy, saying, "It’s not working. So far, the economy is doing fine," though he cautioned that a recession could still be forthcoming, albeit delayed. Yea, the overwhelming ambivalence here seems to be prevalent in all economic circle. Not a comforting message.

Historical Context and Evolution

The concept of the inverted yield curve as a recession predictor gained traction with a 1986 dissertation by Campbell Harvey, now a finance professor at Duke University. Although the yield curve was discussed among Wall Street professionals and Federal Reserve officials in the 1990s, it became widely recognized only after the 2008 financial crisis.

Reasons for Current Doubt

Despite its track record, the yield curve has limitations. It reflects investors' expectations of future Federal Reserve interest rate cuts but does not clarify the reasons behind those expectations. Such rate cuts could signal a recession or merely preemptive measures to stabilize growth. Historical instances have shown that external factors, such as the 1990 oil price surge or the 2020 pandemic, can influence economic outcomes regardless of the yield curve's behavior.

Economic Indicators

Recently, a recession seemed likely due to high inflation and aggressive rate hikes by the Fed in 2022. However, some economists remained optimistic, suggesting that inflation could decrease as businesses adjusted post-pandemic, potentially averting a recession. To date, inflation has been tempered with only a slight increase in unemployment, boosting investor confidence and driving up the S&P 500 by 24% last year and an additional 11% this year. However, what goes up must come down, and then up again as treasuries continue to wildly gyrate (10YT up 0.25% in just two weeks) on strong economic news. Following suit, the S&P pulls back as the cost of borrowing looks to remain elevated for longer. It is a vicious circular pattern that has repeated itself as investor digest every shred of data supportive of a rate cut.

Interesting enough even Harvey, who inked the concept linking the inverted yield curves to recessions, acknowledged the complexity of forecasting the U.S. economy with a single measure from the bond market.

Definitions and Measures

There is no single definition of an inverted yield curve. Investors typically compare the 2-year and 10-year Treasury notes, while some economists prefer the 10-year yield against the 3-month or 1-year yield. The length of time an inversion must hold to portent recession after inversion varies but we are set to blow the roof off the existing date set. The ongoing inversion commenced in early June 2022. Historically, recessions have materialized within nine to 24 months following an inversion where the 10-year yield falls below the 1-year yield for at least a month. Despite this, the current economy keeps chugging along with a robust workforce and healthy consumer spending. More so than any other inversion period in history. The prolonged inversion has become normalized for many investors. Unfortunately, to the point where it would take substantial negative data and cage rattling to anticipate the yield curve returning to a normal state.

With one less reliable tool (at least in this cycle) to forecast economic conditions, the onus is on us, CRE professionals, to separate market noise from true market distortions. Higher and longer lending rates have played havoc on CRE values, that is a truth. Time to use good old market knowledge and a healthy risk appetite to unlock value. We’re here to help you with that analysis so reach out to us at Kidder Matthews anytime.