An inverted yield curve is a strong indicator that a recession is on the horizon. Economists say that a yield curve is “inverted” when the yields of short-term bonds exceed those of long-term bonds.
The above chart displays ten-year and three-month treasury yields from September 1981 onward. The red line represents the yield of the 10-year treasury note while the blue line represents the yield of the 3-month treasury note. The gray bars represent recessionary periods as determined retrospectively by the NBER.
Notice how the intersection of the two lines has preceded a recession in every instance, but there can be a lag of 18 months or more. For this reason, the ten-year and three-month inversion can be thought of as a reliable but somewhat imprecise leading indicator. It tells us that a recession is likely but not when it will occur. Smoothed recession probabilities and the Sahm rule are better at telling us whether a recession is imminent or already underway.
While academics tend to emphasize the spread between the three-month and ten-month yields, traders and the media often look to the spread between the ten- and two-year treasuries.
The spread between the ten- and two-year treasuries has done a good job of predicting the last three recessions. But also notice how many more false positives this measure creates, especially if we are looking at the 1980s and 1990s.
According to ten- and two-year spread, the yield curve inverted on April 1st of 2022. If it is accurate, then there is a good chance that we are going to experience a recession in 2022 or 2023.