EXPLAINER: Why bond yields may be warning of a recession

One of the more reliable warning signals for an economic recession is starting to shine.

The “yield curve” is watched for clues to how the bond market is feeling about the U.S. economy’s long-term prospects. On Tuesday, a closely followed part of the yield curve gave investors some cause for concern.

WHAT IS THE YIELD CURVE?

At the center of the investing world are Treasurys, the IOUs the U.S. government gives to investors who lend it money. The yield curve is a chart showing how much in interest different Treasurys are paying.

On one end are shorter-term Treasurys, which get repaid in a few months or a couple years. There, yields closely follow expectations for what the Federal Reserve will do with overnight interest rates. On the other end of the chart are longer-term Treasurys, which take 10 years or decades to mature. Their yields tend to move more on expectations for economic growth and inflation further into the future.

Usually, longer-term Treasurys offer higher yields than shorter-term ones, resulting in a chart with an upward sloping line. That's in part because investors typically demand higher yields to lock away their money for longer, given the possibility of future rate increases by the Fed and the risk of inflation. But when investors are worried the economy will fall sharply, perhaps because the Fed is pushing short-term rates too high too aggressively, they’re willing to accept less for a Treasury maturing many years in the future.

When yields for short-term Treasurys are higher than yields for long-term ones, market watchers call it an “inverted yield curve.” And when that chart has a downward sloping line, Wall Street starts getting nervous.

WHY CARE?

All the talk about charts and yields is tough to digest, but an inversion in the yield curve is considered to be a reliable predictor of a recession.

Wall Street tends to watch the relationship between the two-year and 10-year Treasury yields for clues to whether the bond market is worried about an economic downturn, even though they have at times inverted without a recession following.

Others market observers, including officials at the Federal Reserve, view the relationship between the 3-month and 10-year Treasurys to be the more important one. Every recession in the past 60 years has been preceded by an inversion of the yield curve between the three-month and 10-year Treasurys.

There’s usually some lag between the two. One rule of thumb says it takes about a year after the three-month Treasury yield tops the 10-year yield before the onset of recession, according to the Federal Reserve Bank of Cleveland.

WHAT'S HAPPENING NOW?

At 0.56%, the three-month yield is still well below the 10-year yield of 2.41%, so no inversion there.

But on Tuesday, the two-year Treasury yield briefly topped the 10-year yield for the first time since the summer of 2019. Other, less-followed parts of the yield curve were already inverted. Though they don't have as good a record of success predicting recessions as the three-month yield versus the 10-year, they show the trend is swinging toward pessimism.

The last time the two-year yield topped the 10-year yield, it took less than a year before the global economy plunged into recession. At that time, though, the bond market did not see the pandemic coming. It was more worried about global trade tensions and slowing growth.

Now, the two-year yield is surging as investors ratchet up expectations for a more aggressive Fed. The central bank has already pulled its key overnight rate off its record low, the first increase since 2018, in hopes of beating down high inflation. It's also preparing to hike rates several more times, and the Fed has indicated it may do so by double the usual amount at some meetings. That has helped the two-year yield more than triple in 2022 alone.

The 10-year yield has also risen, but not as quickly.

SO THE YIELD CURVE JUST REFLECTS THE BOND MARKET'S THINKING?

It could also have real effects on the economy. Banks, for example, make money by borrowing money at short-term rates and lending it out at longer-term rates. When that gap is wide, they make more in profit.

An inverted yield curve complicates that, though. If it causes banks to cut off lending — and thus growth opportunities for companies — it could help tighten the brakes on the economy.

IS IT A PERFECT PREDICTOR?

No, an inverted yield curve has sent false positives before. The three-month and 10-year yields inverted in late 1966, for example, and a recession didn’t hit until the end of 1969.

Some market watchers have also suggested the yield curve is now less significant because herculean actions by central banks around the world have distorted yields. Through the pandemic, the Federal Reserve bought trillions of dollars of bonds in order to keep longer-term yields low, after slashing overnight rates to nearly zero. Soon, it will start allowing those bonds to roll off its balance sheet, which should add upward pressure on longer-term yields.

SHOULD I PANIC?

Fed Chair Jerome Powell would say no. Last week, he said that he pays more attention to the first 18 months of the yield curve than what's going on between the two-year and 10-year yields.

“That has 100% of the explanatory power of the yield curve,” he said, and it's not inverted.

“The economy is very, very strong,” he said, pointing to its continued growth and the healthy job market.

And even if the two-year and 10-year Treasury yields inverted on Tuesday, it may end up being just a temporary blip rather than a lasting trend.

Many investors, though, are getting more worried about the risk of a recession or the possibility of “stagflation,” which would be the painful combination of high unemployment and high inflation.

The bond market, of course, also seems to be more pessimistic. Just look at the yield curve.