BOND PRIMER: Does Inverted Yield Curve Indicate Recession?

This brief post presents simple historic proof that inverted yield curves predict recessions. I am posting it in anticipation of an article this week in which the Federal Reserve surprisingly admits it is solely responsible for creating recessions.

Does an inverted yield curves predict a recession?

An inverted yield curve has happened shortly before every US recession because the Fed has always tightened up financial conditions at the end of its recovery programs by raising interest rates until the yield curve inverts. That would be an inversion of the yield curve ranging from two-year notes paying a better bond yield than ten-year notes to two-year notes paying more than 30-year bonds.

Here is one of the Fed’s own graphs that proves inverted yield curves have preceded every recession in, at least, the last forty-five years where the blue line represents how much interest on 10-year notes was above (as it should be) or below 2-year notes (inversion):

You can see that, after every yield-curve inversion, recession (the gray zones) followed. That is as much as to say the Federal Reserve, once it starts tightening financial conditions to thwart the possibility of runaway inflation, always keeps turning the screws down on interest rates until it manages to convince investors in the so-called open marketplace that a recession is imminent. As explained in my article on inverted yield curves (linked above), investors demand higher interest in the short-term than they do further out where they think the economy will be doing better if they think recession is imminent.

Federal Reserve Insanity or Deceit?

If you click on the link in the caption to the graph, you’ll see that even the Federal Reserve is aware of the fact that it tightens interest until it creates recessions. Apparently it doesn’t care because it continues to do this every time. One almost has to conclude that either 1) the Fed wants to create recessions or 2) the Fed is insane because the common definition to insanity is to keep repeating the same behavior and expect different results.

It is not as if the Federal Reserve could not see a yield-curve inversion coming long in advanced in 2018 (and every other time it has taken this path). After all, their own graphs show a trajectory that was clearly headed toward an inverted yield curve, which actually began to form in December, 2018:

You can see an inverted yield curve recession coming from a mile away.

Whether the Fed is just pathetically ignorant of the things its own graphs and data and its own writerstell it (and tell us) or insane or just evil (i.e., wanting to intentionally crash the economy while pretending it doesn’t), I’ll leave up to you; but apparently Janet Yellen, former Fed Head, is going to cop a plea of innocence by reason of insanity:

Now there is a strong correlation historically between yield curve inversions and recessions, but let me emphasize that correlation is not causation, and I think that there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.

Seeking Alpha

Well, when it correlates precisely every single time, I think causation is obvious. If you sit on my chest and I can’t breath, it’s always possible I cannot breath for some other reason, such as I’m having a heart attack; but, if you sit on my chest over and over, and every time I cannot breath, I’m going to conclude you are definitely the cause of my suffocation. With such precise and constant correlation, odds of anything else being the cause become infinitesimal.

Given that Yellen looks at this Fed chart and still doesn’t believe the Fed is the cause and evens says she believes “may have changed” this time, Yellen might as well just say the Fed is going to continue doing exactly the same behavior it by tightening until a recession but anticipates different results this time. That fits most people’s common definition of insanity to a “T.” Nearly fifty years of history in the graph above says, “Good luck with that!”

Fed creates inverted yield curve recessions

Recessions average about 18 months in length, so investors who are anticipating a recession in the next six months are not going to want to invest in treasury securities that are shorter than two years because they don’t want to roll their money over to a new investment in the middle of a recession when they are fairly certain the Fed will be lowering interest.

It is about betting what the Fed will be doing with interest rates in the future, so determined is the entire bond market by Fed policy. Investors know that, if we go into recession, the Fed will slacken interest rates. Thus the yield curve inverts to where longer-term bonds pay more interest than shorter-term notes or bills.

Whenever the Fed pushes investor concerns that far into fearing near-term investments more than long-term investments, the economy always crashes into recession. That is because, at that high level of concern, financial markets start to seize up. And, as explained in my yield curve inversion article, finances start to stand on their head when short-term credit costs more than long-term credit as the same risk level.

Think of it this way, if investors in the safest of all investments, US treasuries, are that concerned to where they need higher interest from the government to entice them into safe government bonds, how much more so are banks and other institutions and individuals who are making other kinds of much riskier loans?

Once risk concern hits the treasury market that hard, it means everyone making loans everywhere is concerned about where this means things are going so that the whole financial realm looks skewed on the immediate event horizon.

Please let me know in the comments if some aspects of this intentionally simplified article could have been expressed more accurately, while remaining equally simple, and I’ll make the adjustments.

Inverted bond yields a sign of things to come from things gone bye?