There’s been a lot of talk lately about how watching the bond market can provide important clues about where the economy is heading.
In particular, experts often point to the yield curve as a predictor of recessions. The yield curve is a graph showing the interest rate or yield on bonds with different maturities. In a normal economic cycle, a 2-year bond would yield or pay much less interest than a 10-year bond, which makes sense. Investors should get a higher interest rate for enduring eight more years of interest-rate risk.
However, there are times when the yield curve becomes inverted, which means you can get a higher interest rate or yield on a shorter-term bond than a longer-term bond.
For example, the 2-year bond would pay you a higher rate of interest than the 10-year bond. This is highly unusual, but incredibly important because when this happens, it has typically signaled a recession. The last three recessions in the United States have occurred when we had an inverted yield curve – in 1990, 2001, and 2007. A recession more often than not, then triggers a bear market for stocks, like it did in 1991, 2002, and 2008.
An inverted yield curve only happens when bond traders think the economy is going to get weaker. We don’t have an inverted yield curve just yet, but the spread between the 2-year U.S. Treasury bond and 10-year bond continues to flatten. We’re closer to an inverted yield curve than at any time since 2005-07 – right before the financial crisis of 2008.
The San Francisco Federal Reserve Bank has performed research showing that inverted yield curves have correctly predicted all nine recessions since 1955. The bank notes that past recessions occurred anywhere from six months to two years after an inversion.
Yet with unemployment remaining low and second-quarter GDP growth expected to come in as high as 4 percent, the economy seems to be chugging along fine at the moment.
But we’ll continue to watch the bond market and will adjust our strategy as necessary if we see more signs of potential slowing.