Yield Curves & the Recession Signal

The recession signal's track record

The chart above is the classic "inverted yield curve predicts recession". The table below tests it against what actually happened. Every U.S. recession since the mid-1990s was preceded by an inversion in both spreads. "Preceded" fails to tell the whole story. Lead times ranged from 8 to 18 months, far too wide of a window to trade on. Additionally, the curve inverted at least once (June 1998, LTCM/Russia crisis) with no recession following.

The recession-signal chart and table

Both spreads are from monthly-average Treasury constant-maturity yields (10-year minus 2-year, and 10-year minus 3-month). NBER recessions are shaded. A negative spread means short-term yields exceed long-term yields, implying that investors are accepting less compensation to lock up money for a ten years than to lend it for two years or three months. This is historically a sign that the market expects the Fed to be cutting rates by then, usually because of a slowing economy.

7/2022-8/2024, 25 months, is over 30% longer than any prior inversion since 1994. This could be due to a number of different reasons, including the first clean false positive of the modern era, a signal whose lag has just stretched further than history suggested, or a recession that hasn't been dated yet. All three are live possibilities and this page will get updated as NBER's dating committee weighs in. Other explanations are that unprecedented fiscal deficit spending, post-pandemic labor markets, and AI capex-driven investment offset the usual rate-sensitive slowdown. 

Does the curve's shape reflect rate expectations or risk compensation?

A flat or inverted curve can mean two very different things. It can mean investors expect the Fed to cut rates substantially (rate expectations), but can also mean investors are demanding *less* extra compensation for holding long-duration risk (compressed term premium). The latter is often a symptom of excess liquidity, foreign reserve demand for Treasuries, or quantitative easing suppressing the long end mechanically rather than organically.

The chart above uses the New York Fed's Adrian-Crump-Moench (ACM) term structure model. It decomposes the observed 10-year yield into rate expectations and term premiums. 2014-2023 stands out immediately, as the term premium was nearly zero if not negative for most of the decade. QE-era Investors were effectively paying for the privilege of holding long bonds rather than being compensated for the risk. In 2022 as the Fed hiked (quantitative tightening), Treasury issuance ballooned (fiscal deficit), and the term premium turned positive for the first time in over a decade. Investors started demanding compensation for duration risk again.

Which equity styles lead when the curve steepens or flattens?

The curve's direction of travel has mattered for sector and factor leadership as it changes the relative cost of capital and earnings sensitivity of different business models. When short rates fall faster than long rates (a bull steepener) (usually during QE), cyclicals and financials tend to be the biggest beneficiary as growth expectations improve. When long rates are rising faster than short rates (a bear steepener) (often on inflation), it tends to hurt long-duration growth stocks as their valuations are more sensitive to the discount rate on cash flows far in the future. When short rates rise while the Fed is hiking and long rates lag (a bear flattener), financials and cyclicals are negatively impacted.