Are We Heading into a Recession? Yield Curve Inversion as a Recession Predictor

Abstract

Yield Curves reflect the borrowing and lending rates over a range of maturities within a particular market and currency. Yield curves capture the term structure of interest rates and provide observers with a means of comparing short- and long-term interest rates.

There are different types of yield curves, reflecting the different markets, institutions and instruments investors can choose to secure financing. Government Bond curves reflect the rate of return or yield required for governments to secure financing and likewise Swap Curves reflect the borrowing and lending rates available in Swap markets via interest rate swaps.

Current market yield curves are on the verge of inverting. The returns from long-term Government Bonds are lower than the equivalent short term bonds and borrowing money long-term is cheaper than short-term borrowing. This is unusual, typically long-term financing should cost more than short-term financing, not less.

In US markets inverted yield curves have been a reliable predictor of recessions. Each time the yield curve has inverted the US economy has entered a downturn within the subsequent 18 months. This has been the case with only one exception in the last 40 years. In this paper we review firstly what a yield curve is. Secondly we discuss the term structure of yields and interest rates and thirdly we outline the yield spread and explain why an inverted yield curve is a good recession predictor and indicator of heightened recessionary risk.

Finally we conclude with an estimate of the likelihood of a US recession in the next 12 months based on current market information.

Keywords: Yield Curves, Yield Spreads, Term Structure, Inverted, Recession, Prediction, Early Economic Indicator, Federal Reserve

JEL Classification: E03, E17, E31, E32, E43, E47, E58, F62