Could the inverted yield curve indicate a recession?

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News broke yesterday that the bond market had seen an “inverted yield curve” in the US and UK. The Dow Jones tumbled 800 points, and the conversation spread across the internet, even prompting a tweet from US President Donald Trump: “CRAZY INVERTED YIELD CURVE!”

However, this has brought up the question: What exactly is the yield curve, and what does its inversion mean?

An inverted yield curve occurs when the interest rates on short-term bonds have become higher than the interest rates on long-term bonds. Typically investors expect greater return on long-term bonds as it requires their investment to be locked up for longer.

Yield refers to the earnings generated on an investment over a specific period of time. When the yield curve inverts, investors are signaling that they are worried about the long-term economic environment.

Specifically, on Wednesday yields on 10-year US Treasury bonds dipped below the yield on a two-year Treasury bond for the first time since 2007. The 30-year also slipped to a record low.

We can see the investor dynamic at play in other markets as investments are moved into other long-term investment options. Gold prices, for instance, rose to a fresh six-year high on the same day.

So why is so much store put into the yield curve? In general, economic indicators are far from reliable, but an inverted yield curve has preceded every US recession since 1955.

Further muddying the water is the US Federal Reserve interest rate. Last year the central bank began gradually raising interest rates to prevent the economy from overheating. President Trump has taken issue with these raises, which likely provoked his Twitter statement that Jerome Powell and the Fed are “clueless.”

Last month, the Fed made its first rate cute since 2008. An inverted yield curve may lead to further rate cuts this year as the central bank left the door open to further cuts. By cutting rates further, the Fed could be looking to prevent a possible recession.

A US recession is far from a sure thing, however. Recent reports suggest the US economy grew by 2.1 percent in Q2 2019, with consumer and federal government spending accounting for the bulk of growth. In July, the US Labor Department reported 164,000 jobs added to the economy, the 106th month of job growth in a row.

The last inversion occurred in December 2005, with the Great Recession following in December 2007. This two-year timeline is not the standard, however.

Every time the yield curve inverted the timeline has been different – in 2000 it inverted mere months before the dotcom bubble burst. Historical analysis would suggest that 18 months is the average amount of time before trouble hits the equity markets following an inversion of the yield curve.