Market Watch: What is an inverted yield curve and does it mean a recession is coming

If you've been scanning financial news lately you might have seen headlines warning that the US Treasury yield curve has inverted - something that traditionally means a recession is on its way.

But what exactly is an inverted yield curve, how good a predictor of recession is it, and could it be wrong this time?

The yield curve "is the shape of interest rates" plotted on a graph, says Pie Funds chief executive Mike Taylor.

It should normally be a curve that is rising to the right of a graph, indicating that yields are higher for bonds that are held for longer terms.

If you think about the interest on term deposits, for example, banks offer a higher rate of return the longer you are prepared to lock into a fixed term.

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The inversion means that shorter-term rates (like those for two-year treasuries) are higher than the longer-term rates, said Taylor.

In other words, bond investors get paid more to hold shorter-term US government debt than they do for holding it for a longer term.

"We get that because we have central banks trying to curb inflation, or slow an economy down, by putting up shorter-term rates, said Taylor.

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"But then we have markets going: well, actually I'm not so sure about this, maybe this is going to lead to a recession, so the longer-term rates come down and then you get this inversion."

So the inversion is broadly a sign of pessimism about the long-term outlook for an economy.

"It seems to be that the inversion of the yield curve, has been a very good predictor of economic recessions, for the last 60 or 70 years," Taylor said.

According to US Federal Reserve research, an inverted yield curve has preceded all nine US recessions between 1955 and 2019, with a lag time ranging from six months to two years.

Last week the US 2-year Treasury yields and 10-year yields inverted for the first time since 2019.

That means the interest rate on the 2-year note was higher than that on the 10-year note.

How worried should we be about that?

"Some commentators are saying that we shouldn't put as much emphasis on the yield curve as we used to," Taylor said.

"Because since Covid there's been so much distortion to interest rates by the Federal Reserve that maybe it doesn't mean what it used to mean."

But there's still enough people paying attention to it that it can't be ignored, Taylor said.

While a recession in the next six months to two years was plausible, it didn't mean markets were due for a big sell-off, he said.

"Sometimes markets move ahead of a recession. It could be a mild bear market [a fall of more than 20 per cent]. We've already lived through a bear market on the Nasdaq in the last four months."

There were a lot of other factors that would influence equity prices, he said.

Most markets had moved in to correction territory [off by at least 10 per cent] in the first few months of the year, but the past couple of weeks had seen stocks rally.

One reason for that was the initial shock of the war in Ukraine had been priced in.

A Ukrainian serviceman walks next to the wreck of a Russian tank in Stoyanka, Ukraine, March 2022. AP Photo.

"That's historically what tended to happen with conflicts around the world," Taylor said.

The second thing was that some of the fear about rising interest rates had abated as the US Federal Reserve delivered its first hike and laid out the path for further hikes.

"It was almost as if the fear of it was worse than the reality of it."

But there were still risks on the horizon, he said.

The situation with Covid in China had the potential to extend supply disruption and push inflation higher.

That could mean central banks having to push harder with more rate hikes than planned.