The main measure of the yield curve briefly deepened its inversion on Tuesday — with the yield on the 10-year Treasury note extending its drop below the yield on the 2-year note — underlining investor worries over a potential recession.
But while inversions are seen as a reliable indicator of an economic downturn, investors may be pushing the panic button prematurely. Here’s a look at what happened and what it might mean for financial markets.
What’s the yield curve?
The yield curve is a line plotting out yields across maturities. Typically, it slopes upward, with investors demanding more compensation to hold a note or bond for a longer period given the risk of inflation and other uncertainties.
An inverted curve can be a source of concern for a variety of reasons: short-term rates could be running high because overly tight monetary policy is slowing the economy, or it could be that investor worries about future economic growth are stoking demand for safe, long-term Treasurys, pushing down long-term rates, note economists at the San Francisco Fed, who have led research into the relationship between the curve and the economy.
They noted in an August 2018 research paper that, historically, the causation “may have well gone both ways” and that “great caution is therefore warranted in interpreting the predictive evidence.”
What just happened?
The yield curve has been flattening for some time. A global bond rally in the wake of rising trade tensions pulled down yields for long-term bonds. The 10-year Treasury note yield /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y -4.45% fell as low as 1.453% on Wednesday, trading around 4 basis points below the yield on the 2-year note peer /zigman2/quotes/211347045/realtime BX:TMUBMUSD02Y +7.62% .
The inversion on this widely-watched measure of the yield curve’s slope had already taken place two weeks ago, when signs of economic weakness across the globe drew investors into haven
Why does it matter?
The 2-year/10-year version of the yield curve has preceded each of the past seven recessions, including the most recent slowdown between 2007 and 2009.
Other yield curve measures have already inverted, including the widely-watched 3-month/10-year spread used by the Federal Reserve to gauge recession probabilities.
Is recession imminent?
A recession isn’t a certainty. Some economists have argued that the aftermath of quantitative easing measures that saw global central banks snap up government bonds and drive down longer term yields may have robbed inversions of their reliability as a predictor. According to this school of thought, negative bond yields in Europe and Japan have forced yield-starved investors to the U.S., artificially depressing long-term Treasury yields.