Mar 22, 2019 (US time) is the date that marks the inversion of the yield curve of US Treasury Bills. Since the Federal Reserve announced to stop increasing interest rate this week, the market bets for a recession, or even a global recession. The 10-year yield rate drops abruptly from 2.54% to 2.44%, thus resulting in an inverted yield curve if the 10-year minus 1-year yield spread is measured. In general, long term yield rates are almost always higher than short term yield rates (according to Fisher’s Theory of Interest), yet an inverted yield curve means that short term yield rate is higher than long term yield rate. Table 1 below shows the changes of all the yield rates in March 2019.
The inversion can be clearly depicted by comparing the yield curves in 2011 on the same day of Mar 22. Figure 2 shows the two yield curves, one on Mar 22, 2011 and the other on Mar 22, 2019. The 2011 curve is upward sloping and is a typical yield curve, while the 2019 curve is flat or even downward sloping, which is an abnormal yield curve. A flat yield curve means a zero spread, and a downward sloping yield curve implies a negative spread.
In fact, the spread has been decreasing for almost a decade, Figure 3 shows the spread between the 10-year and the 2-year yield rates (which is available from FRED) in the past 40+ years. The current reduction of the spread started since 2011, and this one may be one of the slowest one.
The reason why the whole world is so nervous about the inversion of the yield curve is because it predicted highly accurately for almost all the recent past recessions. After 6–18 months of an inversion of the yield curve, then recessions came. Those grey colored bars are referring to the recession sessions. The latest one is the 2008 Global Financial Crisis, which is about 1-year after the previous yield curve inversion.
Table 4 shows the previous 5 recessions that all followed an inverted yield curve. It happened every 8–10 years in the previous 4 recessions, and the latest 2019 inversion has lapsed from the previous one for 14 years.
Even though it is quite accurate in predicting recessions, why an inverted yield curve can predict a recession is not so straightforward. Can you explain the financial logic behind? Let’s discuss it later.