- A yield curve inversion is when short-term interest rates are higher than long-term interest rates.
- This closely-watched signal suggests markets are out-of-whack and something has to give, which often takes the form of an economic recession.
- The difference between the US 10-year and 2-year Treasury rates is just over 20 basis points.
The difference between short-term and long-term interest rates is quickly narrowing, and that means an economic recession could be right around the corner.
The yield curve, which plots the interest rate of various bond maturities, is on the verge of an inversion. That means short-term interest rates are almost higher than long-term interest rates. As of Monday, the US 10-year Treasury had a rate of 2.24%, while the US 2-year Treasury had a rate of 2.03%. Meanwhile, the 5-year and 10-year rates are already slightly inverted.
The convergence of interest rates comes as the Federal Reserve kicked off its rate hiking cycle for the first time since late 2018, and as inflation soars to 40-year highs. With many investors believing that the Fed is "behind the curve," meaning rates are still low while inflation is high, the Fed is expected to play catch-up with up to six more rate hikes this year.
The relatively small difference of only 21 basis points between the US 10-year and 2-year Treasury notes calls into question why an investor should lend money to the government for 10 years, which inherently carries more risk, rather than for a shorter period of time.
Given the fundamental investment principal that taking on more risk should warrant the potential for a bigger reward, a yield curve inversion often suggests markets are out-of-whack and something has to give. That "give" usually takes the form of an economic recession, which resets interest rates, inflation, and growth rates.
Yield curve inversions have a good track record of happening right before a recession, according to a Friday note from Bank of America. The bank said eight of the last 10 and 10 of the last 13 recessions have been preceded by the 10-year rate falling below the 2-year rate.
"There was one yield curve inversion in the mid-1960s that did not precede a recession and the yield curve did not invert ahead of the three recessions between the mid-1940s and early 1950s," BofA said.
But even if a yield curve inversion does precede an economic recession, the lead time between the two could be up to two years, according to the note.
Since 1956, it has taken between five and 24 months for a US recession to start after a yield curve inversion. And that wide lead time can also be seen in the S&P 500's peak following an inversion. Since 1956, it has taken between two and 22 months for the S&P 500 to peak after a yield curve inversion.
Also complicating the practice of timing investment decisions on a yield curve inversion in this cycle is that the yield curve between the 3-month and 10-year Treasuries is steepening, meaning that the short-term interest rate is falling while the long-term rate is rising. This divergence could mean a yield curve inversion between 2-year and 10-year treasuries is not inevitable, even though it's close to happening.
"The BofA US Economics team suggests that we should not fear yield curve inversion. It is not the standalone indicator of recessions as it once was," BofA said.
