The Yield Curve is About to Flip. Does That Mean Anything, Anymore?

For years there have been warnings of a coming recession. Why/? The yield curve — the difference between yields of two different Treasury instruments had steadfastly been inverted. According to long-standing theory, that meant a recession within the next two years.

But it hasn’t happened. And now the yield curve is headed back to “normal” waters. Has one of the country’s favorite economic obsession signals passed its sell-by date?

A yield curve inversion is when the yield on the shorter-term instrument is higher than that of the longer-term one. Economists and traders typically look at the difference between the two-year yield and the 10-year, but there are other comparisons. The Federal Reserve Bank of New York often compares the 10-year and the 3-month.

In comparing the 10-year and two-year, the curve inverted on July 5, 2022, and remains so, 765 days later. Look at the 10-year versus 3-month; that curve inverted on October 25, 2022, and like the 10-year/3-month, it remains inverted, in this case, 644 days at the time of writing.

The previous record was a 10-year to two-year spread from August 17, 1978, to April 1980, or 623 days. Currently, the difference has almost dropped to zero. On July 24, the difference dropped to 0.09.

Inversions happen because short-term debt has higher yields than longer-term, meaning that longer-term prospects are worse. So investment income on longer-term bonds will continue to fall. Because those and bond prices move opposite to one another, as investors seek higher short-term yields.

Typically, an inversion reversal, known as a disinversion, happens when the economy slows enough that investors assume the Fed will soon lower rates to stimulate activity. Investors buy shorter-term bonds because of longer-term uncertainty. More demand on bonds raises the price, and so lowers the yield. Eventually, the balance between long- and short-term yields is restored.

Back in March, Reuters polled 34 bond market experts. Almost two-thirds said that yield inversions don’t hold the same predictive power that they had in the past.

“If you have these two things going on together — insatiable demand for the long-end from real money like pension funds and the Fed keeping front-end rates higher because of the resilience of the economy — the curve will stay inverted for a while,” Zhiwei Ren, portfolio manager at Penn Mutual Asset Management told Reuters at the time.

However, in a new article, Reuters quoted what Deutsche Bank strategist Jim Reid said in a note on Thursday: “In recent cycles, a re-steepening back out of inversion has occurred shortly before a recession, so that’s one to keep an eye on, given how it’s moved ahead of the past few downturns.”

And there is that pesky relationship between the 10-year and 3-month yields. Still deeply negative, it’s too soon to rule out.