2019’s Yield Curve Inversion Means A Recession Could Hit In 2020

In May 2019 the yield curve inverted which means shorter term U.S. Treasuries had a higher yield than longer term ones. In particular, the 3-month Treasury’s yield became higher than the 10-year on May 23 and except for one day in July it remained inverted until October 10, for a total of four and a half months.

This created a lot of angst among investors at the time since an inverted yield curve is a sign that a recession may transpire. In fact, this has occurred for the last three recessions since 1990, with them starting 13, 8 and 18 months, respectively, after the start of the yield curve inverting.

Probably because the Fed has become more accommodative, investors seem to have come down with amnesia that there is a lag between the inversion of the yield curve and the start of a recession. If history is repeated a recession could start between January and November 2020.

Past three recessions and the yield curve

While the stock market has a spotty track record at best of forecasting a downturn in the economy, the inversion of the yield curve has been pretty reliable. One of the recession signals that worried investors in the middle of 2019 was the U.S. 3-month Treasury having a higher yield than the 10 year.

There are times when the 3-month and 10-year Treasuries become inverted for a few days before there is a sustained period of them being reversed. For this analysis I use the start of the sustained period to determine the time lapse between the inversion and the start of a recession to account for any noise in a few days worth of data.

Over the past three recessions, when the result turns negative the economy has entered a recession 8 to 13 months later all three times since 1990. The key data listed below is this lag between the initial date of the inversion and the start of a recession.

1990 to 1991 recession

• Day of first sustained inverted yield curve: May 24, 1989
• Last day of inverted yield curve: August 25, 1989
• Length of inverted yield curve: 3 months
• Largest amount of inversion: 35 basis points
• 3-month yield at that time: 8.50%
• 10-month yield at that time: 8.15%

• Start of the recession: July 1990
• Timeframe from start of inverted yield curve to recession: About 13 months

2001 recession

• Day of first sustained inverted yield curve: July 7, 2000
• Last day of inverted yield curve: January 19, 2001
• Length of inverted yield curve: 6 months
• Largest amount of inversion: 95 basis points
• 3-month yield at that time: 5.87%
• 10-month yield at that time: 4.92%

• Start of the recession: March 2001
• Timeframe from start of inverted yield curve to recession: About 8 months

2008 to 2009 Great recession

• Day of first sustained inverted yield curve: July 17, 2006
• Last day of inverted yield curve: August 27, 2007
• Length of inverted yield curve: 13 months
• Largest amount of inversion: 64 basis points
• 3-month yield at that time: 4.50%
• 10-month yield at that time: 5.14%

• Start of the recession: December 2007
• Timeframe from start of inverted yield curve to recession: About 18 months

2020 recession?

• Day of first sustained inverted yield curve: May 23, 2019
• Last day of inverted yield curve: October 10, 2019
• Length of inverted yield curve: 4 and 1/2 months
• Largest amount of inversion: 52 basis points
• 3-month yield at that time: 1.99%
• 10-month yield at that time: 1.47%

• Start of the recession: Unknown
• Timeframe from start of inverted yield curve to recession: Unknown

Note that interest rates in 2019 were significantly below rates in the previous three recessions. This means on a percentage basis the largest inversion of 52 basis points in 2019 is greater than the earlier recessions.

Negative interest rates could explain the inversion

There is about $11 Trillion in various debt that has negative interest rates with almost all of it in Europe and Japan per Bloomberg (and almost $17 billion in August 2019). This means that the person or organization owning the debt will receive less money back than what they deposited.

One impact from negative rates is that some international investors have bought longer term U.S. Treasuries to receive a positive return, or more money when it matures, than what they invested. As foreign investors buy U.S. Treasuries this increases their price and lowers their yield. This situation could have caused the 10-year to fall more than it normally would and therefore create an inverted curve for a non-recession reason.

Probability of a recession

The Federal Reserve Bank of Cleveland and Haver Analytics estimates the probability of a recession based on the yield curve. The latest calculations show that the probability of a recession peaks at 43% in August 2020 but decreases to 27% a year from now. Consumer spending is keeping the country from entering a recession since business investment has been negative for two quarters, as it is essentially in a recession.

Note that the probability did not reach 100% in any recession and only reached 50% in 3 of the past 8. While few are expecting a recession to occur in 2020, if consumer spending growth continues to slow GDP growth could remain at 2% or below or even turn negative for a quarter.