Here's What A 10-Year/2-Year Term Spread Inversion Tells Us About Economic Growth And Recessions

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by: David Rice
Summary

The real value of a 10-year/2-year spread inversion is that it signals when the business cycle has peaked.

Although a 10-year/2-year inversion can have several inversions, it is the first inversion point that generally occurs near the business cycle peak.

Prior to the 2001 recession the term spread inverted early; I will explain the probable reasons why this happened.

The more I have studied term (yield curve) spreads, the more I believe they are given too much importance. However, term spread inversions do provide useful signals. For example, my analysis indicates that the initial inversion of the 10-yr/2-yr term spread occurs when a business cycle is at or near its peak, or when investors believe the business cycle is near its peak.

Is the 10-year/2-year term spread predictive?

In an article in the San Francisco Fed newsletter, titled Information in the Yiield Curve About Future Recessions, the authors, Michael D. Bauer and Thomas M. Mertens, state that following the 10-yr/2-yr spread is often preferred “because the former summarizes long-term perceptions and sentiment of bond market investors, while the latter is viewed as a reasonable indicator of the stance of monetary policy.” However, the article also notes that the 10-yr/3-mo term spread has “strong predictive power of … recessions and economic activity” and is the preferred measure used in academic research (I use the 10-yr/3-mo on the BaR Analysis Grid©). Finally, the Fed has started to use “the six-quarters-ahead forward rate and the three-month yield” as it has demonstrated that this measure is even a better predictor than the 10-yr/3-mo, although, in my opinion, the difference is slight.

Investor perceptions and sentiments are determined by current events

The usefulness of the 10-yr/2-yr term spread is that it captures the "perceptions and sentiment" of investors. A flat or inverted term spread indicates that investors are worried about near-term economic growth. Fearing a slowdown, investors move money into long-term investments, which drives down long-term yields. This will flatten, and sometimes invert, the term spread.

However, this behavior is not caused by investors peering into the future. Instead, it is caused by something that is happening at the moment, something significant enough to signal to investors that the economy is ready to begin, or has already begun, a slide towards a recession.

As I will demonstrate, for the 10-yr/2-yr spread that something is the perception that the business cycle has peaked and the economy is beginning a downward slide.

A term spread inversion is not a single episode

It is important to know that 10-yr/2-yr term spread inversions are events that on average stretch over 22 months, based on the four inversions marked in Chart 1 (whatever happened between the 1980 and 1981 recessions is unique to that double recession). Looking at daily yields, an interesting picture emerges. After the term spread first inverted, the 10-yr/2-yr spread twisted together for a period that lasted a year and a half or longer (area within lines).

Chart 1Four business cycles Source: Department of Treasury via FRED

Term spread inversion event prior to the 2007 – 2009 recession

Chart 2 shows the period during the 10-year/2-year inversion prior to the 2007 – 2009 recession. The circles show the four times that the yield curve inverted. The entire event lasted 20 months.

Chart 210-year and 2-year spread inversion

Source: Department of Treasury via FRED

Table 1 breaks down the inversion period shown in Chart 1. It could be argued that the one-day inversion in December 2005 isn’t relevant. However, as shown on Chart 1, after that date (far left circle), the yield curve spread was nearly flat until it inverted again in February 2006, two months later (second left circle). From there on, the yield curve spread stayed within a fairly tight range. For this reason, I view the period from December 2005 until the end of the last inversion in June 2007, 20 months, as one inversion ‘event.’ Investor perceptions and sentiments were consistently pessimistic over that period. It may be that that the length of the inversion reflects the range of investors' risk tolerances. More risk adverse investors seek safe harbors earliest, and more risk tolerant investors do so later.

2001 yield curve inversion As shown in Table 1, the first of the four inversions occurred 24 months prior to the recession. Although the actual inversion periods varied from 1 day to 9 months, during the entire 20-month inversion period, the range of spread remained fairly tight, with a high of 0.21% and a low of -0.19%.

Term spread inversions prior to 1980, 1990 – 1991 and 2001 recessions

As shown in Table 2, we see a similar pattern prior to the 1990 - 1991 and the 2001 recessions. However, the inversion prior to the 1980 recession played out differently. The yield curve inverted only once and remained inverted until three months after the recession began. It inverted 17 months prior to the recession and remained inverted for 20 months.

Prior to the 1990 – 1991 recession, the yield curve inverted three times, the first occurred December 1988, 20 months prior to the recession. This inversion lasted seven months. The next inversion occurred on August 1989, 11 months prior to the recession, and it lasted 2 months. The final inversion happened in March 1990, four months before the recession. It lasted one month. The total inversion event lasted 17 months. During this period, after the initial inversion, the yield curve spread fluctuated between a high of 0.31% to a low of -0.44%.

Yield curve inversions for 3 recessions The term spread prior to 2001, also shown in Table 2, inverted twice. The first occurred well before the recession, 33 months. The second inversion didn’t occur until 18 months later.

In terms of predicting a recession, the June 1998 inversion, which lasted two months, did occur before the recession, so it was “predictive.” Yet, it was 33 months prior to the recession. The average for the other three inversions was 20 months before a recession. Understanding why the June 1998 inversion was early helps explain the nature of the 10-yr/2-yr inversion. I will delve into this situation later.

Summary to this point…

The 10-yr/2-yr term relates the long-term outlook of bond investors with the likely stance of monetary policy.

During the previous three business cycles, the term spread inversion has been an event that lasted an average of 22 months.

The initial inversion dates have varied from 33, 24, 19, and 17 months prior to a recession; hardly a useful predictor of when a recession will start.

What the economy looked like when the 10-yr/2-yr spread inverted

The best way to see if a term spread inversion is meaningful is to place it into the context of economic conditions.

To do this, I will show what the economy looked like when the four inversion periods identified in Tables 1 and 2 started. The initial inversion dates were: August 1978, December 1988, June 1998, and December 2005. The BaR Analysis Grid© is the tool I will use to determine if there were similar economic conditions during these four periods. (If you are not familiar with the BaR, you can read about it here.) I will start with the most recent inversion in December 2005.

December 2005 Inversion

I'm showing this inversion in the context of the business cycle. This is an advantage of the BaR. It clearly shows when the business cycle peaks. Grid 1 shows the 2001 - 2007 business cycle, with the mean of coordinates (MOC) averaged over six months. The months shown are the last month of the six-month period. A six-month average clears statistical noise and emphasizes significant inflection points. As shown, the term spread first inverted in December 2005, which is at the tail end of the business cycle peak.

Grid 1Business cycle 2001 - 2007

Source: econpi.com

Consistency of 10-yr/2-yr inversion with business cycle peak

To more quickly make the point, Table 3 shows whether or not the first inversion that occurred prior to each recession happened at or near the time the business cycle peaked. I'm using the peak period as determined by the BaR. With the exception of the March 2001 recession, the month that the yield curve first inverted matches up well with the month in which the business cycle peaked. However, the first inversion prior to the March 2001 recession occurred 21 months before the business cycle peaked. There was a good reason for this as I will show in the next section.

Yield curve inversion and business cycle peak

(Note: Data for the 10-yr/2-yr spread is only available from 1976 and after.)

Business cycle peak, inversion, and recession

That the 10-yr/2-yr spread would invert at or near the business cycle peak makes sense. This term spread conveys the "perceptions and sentiments" of investors. At the business cycle peaks, a range of economic indicators are slowing. This becomes obvious to investors. Knowing that the economy is slowing, investors begin to act defensively, including the movement of money into long-term assets, which sets up an inversion.

However, as I will show shortly, other factors can intrude and make an inversion more likely. For example, a foreign financial crisis can drive down long-term yields as investors seek a safe haven in Treasury notes.

The purpose of this article isn't to identifying the economic indicators that are faltering and leading to a downturn. Each business cycle has it own unique attributes that lead to its demise. Regardless what the major causes are, when there are enough economic indicators turning down, the business cycle will peak. Coincidentally, as shown, the 10-yr/2-yr spread will invert.

What if the term spread doesn't invert?

If the business cycle has peaked, it doesn't matter whether the term spread inverts or not, a recession is on its way. However, even if the yield curve does not invert, it would probably flatten to a near inversion point.

This illustrates the importance of following other key economic indicators. If the yield curve flattens and a majority of economic indicators are beginning to collapse, and continue to do so, that would signal recessionary conditions. To see how a range of indicators signal a looming recession, go to the Road to Recession web page at the Econ P.I. website.

Why the June 1998 inversion was early

As already shown in Table 2, the June 1998 inversion was unique because it occurred 33 months before the recession. And, as shown in Table 3, it happened 21 months before the business cycle peaked.

Grid 2 show the 1991 – 2001 business cycle with the MoC averaged over six months.

The early inversion in June 1998 makes sense when looking at Grid 2. The economy was having some indigestion during that period. The inversion occurred at a point when investors were receiving negative signals about near-term growth.

Grid 21991 - 2001 business cycle

Source: econpi.com

I’m also showing on Grid 4 the second inversion, which occurred in February 2000. This inversion took place near the peak of the business cycle. Investors got it right the second time.

Why did the 10-yr/2-yr spread invert in June 1998?

Chart 3 displays the 10-yr/2-yr spread during the 1991 - 2001 business cycle. The red circle shows the first inversion point. As seen, the Asian financial crisis had begun nearly a year before. Because of this crisis, investors had sought a safe haven in U.S. Treasuries (Asian Financial Crisis), which pushed down yields towards the Federal Funds Rate (FFR). However, the effects of the financial crisis had diminished by the time the yield curve inverted in June 1998. But, yields were nearing the FFR, making an inversion more likely. The Russian ruble devaluation occurred shortly after the yield curve inverted. (The Benchmark U.S. Treasury Market...). Although it was not a factor at the time of the inversion, it appears to have prolonged the inversion. The 10-yr/2-yr spread remained inverted for two months.

However, the inversion happened between the Asian and Russian crises. An examination of domestic economic affairs indicates what factors that were the final tipping point.

Chart 3Yield curve inversion 1998 Source: Department of Treasury via FRED

The first domestic issue was how high the Federal Funds Rate was after 1994. Notice in Chart 3 how wide the spread was during 1993 and 1994, and then how in 1995 the yield curve goes up and almost inverts. This was due to the Fed increasing the FFR.

As seen in Chart 4, during 1994, the FFR increased from 2.5% to around 6% (the Fed overshot its target rate of 5.5%). This had a chilling effect on the economy, causing it to slump in 1995 (left circle). However, the Fed kept to its target rate of 5.5%, which it held until the latter part of 1998.

Chart 4Real GDP

One effect of the Fed's policy was that the 10-yr/FFR spread nearly inverted at the end of 1995, beginning of 1996 (circle on Chart 5). On December 29, 1995 and January 3, 1996, the 10-yr/FFR spread was 2 basis points. A mere whisker from inversion.

Chart 5Three yields

Source: Department of Treasury via FRED

However, as can also be seen, after the near inversion of the 10-yr/2-yr spread in 1994, that spread return to more normal levels. Chart 5 shows an excellent example of how the Fed has limited influence over long-term interest rates, but how it can control the yield curve (How Might Increases in the Federal Funds Rate...).

Another factor was the decrease in inflation in 1997 and 1998. This too helped push down long-term yields, making it easier for an inversion. (How Did the Economy Surprises Us In 1998?). Despite the drop in inflation, the Fed kept the FFR target at 5.5% (Chart 4). As 1998 approached, the 10-yr and 2-yr yields began to tighten and approached the FFR yields.

Today, we may be puzzled by the Fed's aggressive stance with the FFR, especially since inflation was declining, but the memory of 10% plus inflation during the late 1970s was still in the Fed's collective conscience.

Looking again at when the Fed increased the FFR by over 3% in 1994, as we saw in Chart 4, this action did influence long-term rates for awhile, which affected mortgage mortgage rates. And, of course, short-term loan rates were affected. Chart 6 shows the effect on vehicle sales and housing. They were flat from 1994 to 1997. The left oval is the point at which the 10-yr/2-yr spread inverted. (The right oval is the second inversion, that occurred with the business cycle peak.)

Chart 6Housing and vehicle sales 1998

Sources: Vehicle sales - Bureau of Economic Analysis via FRED; Housing - Department of Housing and Urban Development via FRED

When the 1998 economic slump hit (Chart 4, right circle), investors would have been exceptionally worried about the economy. Yet, investors weren't the only ones who were concerned. The Fed lowered the FFR three times in 1998 to "stave off a slowdown in the U.S. economy" (CNN Money, Sept. 29, 1998) and because of its concern about "'unusual strains' in financial markets" (CNN Money, November 17, 1998). But, the Fed's action were too late to stop an inversion.

The June 1998 inversion seems inevitable. Long-term bond yields had been lowered by the Asian financial crisis and inflation. On the short-term end, the Fed had pushed up the FFR to 5.5%. This was nearly enough. However, added to this was a three year period in which housing and autos, important consumer markets, were flat. The final straw was the 1998 economic slump that worried investors and the Fed.

As we know now, this wasn't the end. Investor perceptions had been wrong. We can understand why the perceptions were wrong, but that is the trouble with a measure like the 10-yr/2-yr spread. It is based on perceptions.

As an aside, one has to wonder how 4% growth was reached in the 90's, especially with the Fed keeping short-term rates so high. The Brookings Institute attributes the growth to deregulation, globalization (increase in free trade, i.e. NAFTA), and innovation (Retrospective on... 1990s). Technology boosted innovation, and it may have been a major reason productivity jumped up in the late 1990s. The Brookings Institute estimates that from 1995 - 2001 service productivity increased 2.6% annually and manufacturing productivity increased 2.3% annually. The difference in productivity then and now explains a lot about why we currently have a lower GDP growth rate.

Inversion based on perception

Knowing that the 10-yr/20-yr spread is perception based is important. Once investors become pessimistic, they behave in a way that will flatten or invert the term spread. So far we have seen that investors' perceptions are pretty good. When the business cycle peaks, a slowdown in the economy will be noticeable. Investors pick up on the negative signals and behave accordingly.

The problem is that perception can be wrong. As we saw with the June 1998 inversion, the business cycle hadn't peaked.

This is a question for us now. Is the current business cycle peaking? There is plenty of concern about trade and growth. Is the pessimism justified?

If investor perceptions are overly pessimistic, then term spreads mean less than we might think.

More than an inversion is needed to cause a recession

If investors perceptions are wrong and economic growth is not slowing, their behavior may play havoc with Treasury yields, but it won't sink the economy.

But, even if investors are right and the economy is slipping towards a recession, initially, the inversion itself is nothing more than a sign of investor sentiment. The inversion will roil financial markets, which will affect the economy, but all of this occurs after investors have reacted to slowing economic grow. The causes of an economic slowdown are already in place before there is an inversion.

Observations

I’m walking away from this analysis with a greater respect for the 10-yr/2-yr spread. The beginning of 10-yr/2-yr inversion events coincides closely with the peak of the business cycle. Investor perceptions that the economy is about to turn are generally sound.

But, as shown with the June 1998 inversion, investors can be overly pessimistic and misread economic conditions.

Investor pessimism can have an adverse effect on yields and financial markets, but if the economy still has some steam, it will chug along just fine.

Currently, markets reflects anxiety and pessimism. For this reason, term spreads may not accurately reflect the strength of the economy.

I plan to use the 10-yr/2-yr term spread inversion to clarify when the business cycle has peaked. But, I won't rely on it alone. It is only one of several indicators to consider. For that reason, I’m going to keep making improvements to the BaR. It gives me a nice monthly, even weekly, snapshot of economic conditions.

Where are we now?

The 10-yr/2-yr spread is around 10 basis points from zero. An inversion could happen within a month. The most recent BaR suggests that we could be at, or near, the peak of the business cycle. Importantly, the BaR’s leading indicators (LD) are now below the MoC.

Grid 6BaR analysis grid December 2018

Source: econpi.com

The Percent MoC from Baseline table, which includes all of the indicators plotted on the BaR, is increasingly showing negative trends. Especially note that over the last year housing and vehicle sales are trending downward (but vehicle sales were positive for the past three months). Remember, during the inversion of June 1998, a false positive, they were beginning to trend upward.

Recession threshold

Source: econpi.com

However, this isn't the only time that the leading indicators have gone below the MoC. This business cycle has had five distinct mini-cycles, as shown in Grid 6. Notice that during 2011, 2016, and 2017 the MoC moved downward, but recovered.

Grid 6Economy business cycle

The MoC is well above the baseline, indicating that there is still a lot of positive economic activity happening. We have chugged along for over 9 years with low growth rate. With historically low interest rates and inflation, could this business cycle have several years left? The Fed has generally jacked up the FFR as the business cycle ages, which undoubtedly slows growth. However, recent statements by the Fed indicate it "could slow the pace of its interest rate increases (Fed Chair... Suggests Interest Rate Hikes May Slow). Such a policy could prolong the business cycle.

Defensive strategy?

If the 10-yr/2-yr term spread inverts soon, most investors will behave as if the economy is on track for a recession. My advice is to plan for that scenario. However, keep your eye on other economic indicators. With the current high-level of pessimism, we could have a false positive inversion. That should present some opportunities for savvy investors.

Data sources for BaR Analysis Grid

Data sources

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.