How Accurate Is the Inverted Yield Curve at Determining Recession Likelihood?

Wthem it comes to the US economy, an inverted yield curve is like the monster under the bed: It’s always lurking, but it doesn’t always come out. Recently it has, however, which could be an early sign of a looming recession.

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A closely watched part of the US Treasury yield curve inverted last week for the first time since April, following worse-than-expected inflation data, Reuters reported. An inversion also made a brief appearance this week.

As previously reported by GOBankingRates, inverted yield curves happen when bonds with shorter maturity periods have higher yields than bonds with longer maturity periods. Normally, the opposite is true. Because longer-term debt carries greater risk than shorter-term debt, bonds with longer durations naturally have higher yields. This is considered a normal yield curve.

When shorter-term debt starts producing higher yields, you get an inverted curve — which in the past has been a fairly reliable predictor of economic trouble on the horizon.

Economists and other financial experts keep an eye on several different yield curves, but the 10-and-2 yield curve — the spread between the yield on the 10-year Treasury note and the yield on the two-year Treasury note — has been the best predictor of past recessions, Kiplinger reported. It cited Anu Gaggar, global investment strategist for Commonwealth Financial Network, who said the 10-and-2 yield curve has inverted 28 times since 1900, and in 22 of those instances, a recession has followed.

But like anything to do with the economy, just because something normally happens doesn’t mean it always happens. As Kiplinger pointed out, although an inverted yield curve might be the most reliable indicator of a looming economic downturn, it can also be very imprese at forecasting the onset of recession.

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It sometimes takes years for a recession to hit following an inverted yield curve. And since recessions typically happen about every five years, an inverted yield curve “isn’t that different from a stopped clock that’s right twice a day,” Kiplinger noted.

In a recent column for the Official Monetary and Financial Institutions Forum, economist Julian Jacobs wrote that the yield curve inversion that took place in March was not necessarily an indication of a coming recession. He pointed out that yield curve inversions that last longer tend to have more predictive power. However, March’s yield curve inversion was quickly reversed.

“Even if the yield curve inverted again, it is far more useful to look at the three-month compared to the 10-year yield curve, which has predicted each of the last eight recessions without fault,” Jacobs wrote. “This is also the Fed’s preferred curve and it is not close to inversion.”

More recent yield curves have been similarly short, meaning they are less likely to be predictors of a recession. That doesn’t mean the US economy won’t slow considerably, however. With so many economic headwinds hitting at once, a growing number of economists are predicting a major downturn in the coming months.

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“Given the current cocktail of war in Europe, inflationary pressure, US indebtedness and inequality, there are several significant macroeconomic toxins that threaten US growth,” Jacobs wrote.

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This article originally appeared on GOBankingRates.com: How Accurate Is the Inverted Yield Curve at Determining Recession Likelihood?

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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