Does an Inverted Yield Curve Portend a Recession?
The bond market is now predicting a recession. In fact, we may already be in one.
The last time I wrote about the bond market was five years ago when interest rates were about to become inverted. When this happens, it simply means you can get a higher interest rate on a shorter maturity bond than on a longer maturity bond. For example, if you wanted to buy the 2-year Treasury bond today, the government would pay you 3.18% in interest. If you wanted to buy the 10-year Treasury bond, you would only get 2.95% in interest. Doesn’t make sense, right? Why would you tie up your money for an additional eight years and receive less in interest? You wouldn’t — unless you think a recession is coming. Guess what? The bond market is now predicting a recession. In fact, we may already be in one.
Today, bond investors think the Federal Reserve’s recent aggressive interest rate hikes will slow down the economy enough to throw it into a recession. We have already seen mortgage rates jump from 3% to almost 6% in the first half of 2022. This means numerous first-time homebuyers may not qualify for a new home. Interest rates on auto loans and credit cards are much higher, too. Anybody who borrows on margin from their brokerage account is paying an extra 2-3% from just a year ago.
These higher interest rates are going to make things a lot less affordable. If things get too expensive, consumers will think twice about making purchases. We are also starting to read about layoffs from the big tech companies in Silicon Valley and a slowdown in hiring on Wall Street. With unemployment at an incredibly low 3.6%, companies will ultimately need to lay off workers to maintain current margins and profits.
If the recession gets bad enough, the Federal Reserve will eventually have to cut interest rates to stimulate the economy. The irony is the Federal Reserve needs to raise interest rates high enough to kill inflation, slow down the economy, and cause higher unemployment, only to turn around and start cutting rates again. This interest rate cycle may take the next 3-12 months. In the meantime, investors in the stock market, homeowners, and workers will likely suffer.
Inverted yield curves are rare occurrences, which is why investors and the media pay such close attention to them. It happened in 1991, 2002, 2008, and most recently (and briefly) in 2020. There is also a very strong correlation between recessions and bear markets. We had bear markets in 1991, 2002, 2008, and in 2020. The difference this time is we are already in a bear market. Let’s see if the inverted yield curve is right: a recession might be just around the corner.
Fred Taylor is a managing director and partner of Beacon Pointe Advisors’ Denver office. He helps individuals and families build wealth, live off their wealth and leave a legacy for future generations. A former economic advisor to Governor Bill Ritter, Fred has more than 35 years of financial services experience.