A recession warning tracked by Wall Street is growing louder, as another measure of the widely watched “yield curve” signals that the United States is headed toward an economic slump.
The yield curve is a way of comparing interest rates, also known as yields, on different maturities of government bonds, from a few months to 10 years or more.
Investors typically expect to be paid more interest for lending to the government for a longer time, partly reflecting the risk of locking up money given the usual expectations for rising growth and inflation.
But short-term yields occasionally rise above longer-term yields, upending the usual situation in the bond market. It’s called a yield-curve inversion, and it means investors are now effectively demanding more money to lend to the government over shorter periods of time. That is an indication investors expect economic growth to decline soon — perhaps within a year — and that the Federal Reserve will need to cut interest rates below where they are currently to help an ailing economy.
Investors have grown increasingly worried about the global economic outlook, as roaring inflation, higher interest rates and volatile markets have destabilized the financial system.
One common measure of the yield curve has already inverted, with the two-year Treasury yield remaining above the 10-year Treasury yield since early July.
At times Tuesday and throughout much of Wednesday, another segment of the curve also inverted, with the three-month yield inching above the 10-year yield. Since the late 1960s, this part of the yield curve has inverted roughly a year before the start of a recession, with a range of six to 15 months, according to calculations by Arturo Estrella, an early proponent of the predictive power of the yield curve.
That track record makes it “a perfect discriminant for whether there is going to be a recession or not,” he said.
At the moment, inflation is stubbornly high, with the Fed clearly communicating that interest rates need to rise even more to tackle it. As a result, expectations for where interest rates will be in three months have moved progressively higher. The three-month Treasury yield has risen from 0.05% at the end of 2021 to just over 4% on Wednesday.
Higher interest rates lead to lower inflation because they cool the economy by raising borrowing costs for consumers and companies. That can lead companies to rethink spending plans or lay off employees, and eventually a restricted economy can become a shrinking economy.
With U.S. inflation running so high, at 8.2% in the year through September, it may take some time before it falls in line with the Fed’s target of 2%. As a result, once inflation has returned to a more comfortable level, the economy may be suffering, and the Fed will need to lower interest rates to stimulate growth again.
That’s why longer-dated Treasury yields are below short-dated yields at the moment. “There is an expectation that interest rates will reach a restrictive level, beyond what the economy can sustain long term, slowing the economy,” said Mark Cabana, an interest rate strategist at Bank of America. “It’s a signal that we are likely heading for a recession.”
Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.