The Case That the Yield Inversion Could Be Signaling a Soft Landing

Treasury bond yield inversions have been long seen as a strong indicator of recessions to come within one to two years. But the academic who, in his 1986 doctoral dissertation, first investigated and expanded on these relationships now says things have changed.

Campbell Harvey, a Duke University finance professor, told MarketWatch that the immediate future may be more so-called soft landing than crash.

Typically, when shorter-term Treasury rates are higher than longer-term, investors are taken as telegraphing that they have more confidence in the near-term economic outlook and that they expect conditions will get worse over time. So, they want higher interest rates in the short run to tie up their money in what they see as turbulent times with more perceived risk.

When one of the long-term/short-term Treasurys yield curve inverted back in July, it was seen as another sign of coming recession. But with interest on the shorter-term instrument higher than on the longer one, back then it was a sign but not the sign.

“Historically, such an inversion has typically preceded economic downturns and therefore is taken as a warning sign,” Ryan Severino, JLL chief economist, told GlobeSt.com in October. “Some economists think the 3 month-10 year is the gold standard [as an inflation sign]. Other economists look at other inversions. Some look at multiple.” That was the month that the 3-month and 10-year yields inverted and have stayed since.

As MarketWatch indicated, the 3-month on Tuesday was 66.3 basis points ahead of the 10-year. The 10-year has been behind the 2-year for about six months now.

And yet, Harvey told MarketWatch that the inversions’ predictive powers are known well by everyone and tend to push businesses and consumers into more careful and prudent behavior that boosts the potential for a soft landing. Although he does note that if the 3-month/10-year inversion lasts through December, he’d be more confident that a recession would be in the offing.

Harvey did point to a number of factors playing into why the spread’s powers of forecasting may be off. Adjusting the yields for inflation shows that the curves are flat, not inverted, and so while associated with slower growth, not so strongly with recession.

Next, it’s highly unusual in a recession to have so much demand for labor, so those who are laid off can find other positions faster. In economic theory, a recession happens when businesses have continued to push too hard, hired too many people, and produced more than market demand will absorb.

Even the large tech layoffs are in areas where the newly unemployed tend to have significant skills needed elsewhere in the economy. Consumers and financial institutions are in better shape than in the past, so the chance of a domino effect knocking everything over is less likely.

And the more cautious behavior by businesses and consumers slows the economy, but potentially without big layoffs.