It’s been many years since Arturo Estrella made a startling discovery that has remained true even after he published his research: inverted yield curves predict recessions. But why?
Before we answer that, let’s make clear what we are talking about, because, as with anything in finance, there are plenty of caveats. Firstly, an inverted yield curve, strictly speaking, means that a short-term yield is larger than a long-term yield for the same type of bond. And when we talk about yield curves that predict recessions, we typically talk about the 2-year and the 10-year Treasuries. When these invert, the chances of a recession increase, and, generally speaking, the longer they remain inverted, the greater the chance of such a recession happening.
However, Estrella has more recently said that other points in the yield curve are also important, and inversions there may predict recessions, too. No matter; the importance of this observation is how accurate it is. For every single recession that has happened in the U.S., Treasuries have shown an inverted yield curve for a sustained period of time between weeks and many months.
So why does this one economic metric succeed in predicting recessions, when so many others fail? And why can’t investors consistently use this to make a lot of money?
Let’s answer the second question first. One of the problem is the lag time. In some cases, the beginning of an inversion is a couple of years before the recession really gets in full swing—which could mean tremendous stock gains before the inevitable market panic in a short-term economic downturn. Thus, shorting the market just when a yield curve inverts could result in tremendous losses before the gains kick in.
However, the indicator can be used to time the probability of a downturn and thus a staggered approach to going from mostly long to mostly short in a hedge fund. Some funds have used this approach to successfully make money during recessions, so it isn’t exactly untrue that this indicator cannot be used to beat the market. It’s just very hard.
But why should this particular metric be so predictive? To answer that, we need to talk about direct effects.
Firstly, there is an obvious direct effect of an inverted yield curve on banking and finance. Because banks are a spread business, meaning they make a profit from borrowing at short-term interest rates and lending at rates tied to long-term rates, an inverted yield curve means offering credit becomes uneconomical—in extreme cases, banks can even lose money. Thus banks stop lending, resulting in a credit crunch that brings the whole economy down.
This doesn’t always happen, however. Instead, the yield curve doesn’t actually cause the recession, but is itself an effect of other factors that produce the recession.
An inverted yield curve that has resulted from the Federal Reserve raising interest rates too quickly can be one such situation. If the Fed decides the economy is too hot and tries to cool it too fast by raising rates, it will succeed—too much. The economy will go cold and turn into a recession all because companies that need to raise capital or refinance existing debt will find new debt too expensive. Defaults and bankruptcies will result, resulting in job losses and possibly even deflation.
If, however, the inverted yield curve is the result of market participants predicting negative growth in the future because of other factors (weakening demand, inflation falling into deflation, productivity losses, trade imbalances, etc.), then the yield curve is simply expressing the market’s correct assessment of other data points that are very obviously negative.
It’s important to remember that the inverted yield curve, while very effective in predicting American recessions, doesn’t work everywhere. Many recessions in many countries have happened with a robust and “healthy” yield curve. The negative interest rates of many European countries may also operate according to different rules than a positive yield curve—this remains poorly studied and understood.
But for analysts looking at America, an inverted yield curve is something to always keep an eye on and pay attention to, even if timing a bet on the curve is never easy.