Economic Impact: Is a recession in the forecast for 2023? Yield curve says yes

While a yield curve inversion does not cause a recession, it is a reflection of underlying economic conditions that may lead to a recession.

This article was originally published in the Richmond Times Dispatch on January 8, 2023. 

Recessions are hard to predict, but many observers are forecasting one for 2023. I’m in that camp as well. The reason many expect a recession might sound complicated, but the principle is actually fairly simple.

In financial parlance, we’re talking about the inversion of the yield curve. While a yield curve inversion does not cause a recession, it is a reflection of underlying economic conditions that may lead to a recession. Here’s what that means and how it might take a bit of time to know the consequences.

The U.S. Treasury Department sells government bonds at various maturity dates – ranging from one month to 30 years – and it pays interest on that money it is borrowing. The “yield curve” simply represents the relationship between interest rates on short-term and longer-term securities.  

Typically, the yield on a three-month Treasury bill is lower than on a 10-year note. That’s because there is lower uncertainty over what will happen in only three months compared with 10 years.  

For example, the holders of a 10-year note have a longer period to worry about the economy. If inflation remains elevated at 7.1% as it was for the twelve months ending in November 2022, they will have less purchasing power when the note matures. To compensate for that risk, they demand a higher interest rate.

So the yield curve typically shows incremental increases between the three-month bill, the one-year bill and so on, up to 30-year Treasuries. 

But the curve is said to invert when the three-month yield is higher than the 10-year yield. When that happens, it indicates that investors have concern about economic growth.  

For the inversion to happen, two things need to occur. One is that short-term interest rates have to rise, and the other is that long-term rates have to stay put or decline.

Here’s what has been happening lately.

Faced with high inflation in 2021 and 2022, the Federal Reserve has indicated that it is committed to returning inflation to its 2% objective. Beginning in March 2022, the Fed has been raising the federal funds rate target – this is what banks use as the overnight rate to lend money to each other. The yield on the three-month bill rises almost in lockstep with the fed funds rate target. 

Recently, the Fed raised the federal funds rate target to a range of 4.25 to 4.5% at their December meeting and some policymakers have indicated that rates will go higher to be more restrictive which should in turn slow demand.

That pushed the three-month yield to 4.34% for the week ending December 29, while the 10-year yield closed the week at 3.83%.  By this measure, the yield curve has been inverted since October 2022.

Typically, when short-term rates rise, so do long-term rates. But this has not happened lately – because investors are concerned that economic growth will slow. That would mean lower yields in the future, especially for short-term Treasury bills. Even though short-term rates are high now, investors do not believe they will remain high over the longer term.

So what do investors do? They buy more long-term Treasuries now to lock in current higher yields for a long period of time. The increased demand for long-term bills causes the price to go up, and the yield comes down – because Treasury prices and yields move in opposite directions. When this process pushes long-term interest rates below short-term rates, it results in yield curve inversion.

Since 1956, an inverted yield curve has preceded every recession by a year or so.  Clearly, bond investors are expecting the economy to slow and yields to fall further.  We may find out this year whether they were right this time. 

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