Recession Indicator: What An Inverted Yield Curve Means For Investors

The difference between the yield on 10-year and two-year U.S. Treasury bonds has dropped below 0.2% and is now at its lowest level since March 2020. Unfortunately, a flattening or negative yield curve can be a very negative indicator for the economy.

What Is An Inverted Yield Curve? The yield curve is a plot of the yields of bonds with equal credit quality but different maturity dates. For U.S. investors, the most commonly referenced yield curve is a plot of 2-year and 10-year Treasury yields, which have yet to invert at this point.

A typical yield curve includes much higher interest rates for maturities further into the future. In a flat yield curve, there's little difference between short-term yields and long-term yields. Sometimes, yield curves can become inverted, a scenario in which short-term yields are higher than long-term yields. Inverted yield curves have historically occurred during periods of economic recession.

Historical Trends: The bad news for investors is that inverted yield curves have preceded each of the past eight U.S. recessions. The good news is they're far leading indicators, meaning a recession is likely not imminent.

According to the San Francisco Fed, each of the 10 U.S. recessions that have occurred since 1955 came between about six months and 24 months after an inversion in the yield curve of two-year and 10-year Treasury yields. The yield curve last inverted in August 2019, about six months before the COVID-19 recession began in February 2020.

Related Link: How To Play Bank Stocks Now That Interest Rates Are Rising

Looking Ahead: On Tuesday, the difference between the two-year and 10-year Treasury yields stood at just 0.18 percent, its lowest level since prior to the last U.S. recession. If the trend in the graph below continues, there could easily be a two-year/10-year yield curve inversion within the next couple of months.

"While the lead times vary and can be long, the typical pattern is that the 2s-10s yield curve inverts, the S&P 500 tops sometime after the curve inverts and the US economy goes into recession six to seven months after the S&P 500 peaks," Bank of America analyst Stephen Suttmeier said last week.

Investors don't seem concerned about any imminent fallout from the flattening yield curve. The SPDR S&P 500 ETF Trust SPY traded higher by 1% on Tuesday, while the iShares 20 Plus Year Treasury Bond ETF TLT was down by about 1%.

Benzinga's Take: An inverted yield curve and rising interest rates have historically been a bad combination for stocks. However, U.S. recessions have historically coincided with or begin shortly after the end of a Federal Reserve rate hiking cycle, not the beginning.

Photo: Courtesy of Mike Lawrence on Flickr