One historically accurate leading indicator for recessions has been an inverted yield curve – that is, a situation in which short-term interest rates are higher than long-term rates of similar credit-quality bonds. The Treasury yield curve was most recently inverted in 2006 and 2000, each time within months prior to a recession. (See Figure 1. Recessions are noted in gray.) Since 1950, the U.S. has suffered 10 recessions, seven of which began within a year of the yield on 90-day Treasury bills exceeding that of 10-year Treasury bonds.
In 2006, it was difficult for large businesses to borrow for periods as short as 30 days, pushing the yield on six-month Treasuries to 5.09%, more than a quarter-point higher than the 4.81% yield on 10-year Treasuries (Figure 2). In hindsight, this inverted yield curve was a clear indication that investors perceived near-term economic uncertainty to be greater than risks further into the future. The worst recession in almost 100 years began only six months following the yield curve’s inversion.
The current economic recovery, now in its 109th month, is the second longest in U.S. history. It will not last forever. But the yield curve has not inverted; it has flattened. The difference between short and long-term rates has compressed, but it has not reversed. A flattened yield curve is a state through which all inverted yield curves must eventually pass. But in the same way that not all 200-lb. people become 300-lb. people, not all flattened yield curves invert.