Many believe a yield curve inversion means a recession is coming.
Last week’s very brief yield curve inversion has increased investor concern, but one expert is calling for cooler heads to prevail.
“I think there are some misconceptions about what yield curve inversions are and what they mean,” says Marcus & Millichap’s John Chang in a new video. A yield curve inversion happens when short-term Treasury rates pay a higher interest rate than long-term Treasuries, and the most commonly tracked version of this is the 2/10 yield spread. That refers to the difference between the two-year Treasury and the ten-year Treasury.
“Many believe a yield curve inversion means a recession is coming, and you may see that in the news a lot in the coming weeks,” Chang says. “But I need to point out that an inverted yield curve is just one indicator and it’s not bulletproof.”
By way of example, Chang notes that the 2/10 yield spread went negative in 1998 and was not followed by a recession – what he refers to as a “false positive.” Other economists, he says, prefer to instead examine the spread between the three-month Treasury and the 10-year Treasury, which allows for a longer historical dataset and theoretically more accurate reading since more pressure is required to move the spread. That spread also shows two false positive yield curve inversions, one in 1967 and another in 1998.
Currently, Chang says, the 10-year Treasury rate is 180 bps higher than the three-month rate.
“That metric hasn’t inverted and it looks like there’s plenty of maneuvering room there,” he says. “Of course this doesn’t explicitly mean there’s no recession coming—but simply that this particular indicator isn’t blinking red.”
Going forward, investors should expect higher than normal interest rate volatility and higher than normal risk of the yield curve inverting, thanks largely to the Fed’s continued efforts to tamp down inflation through a series of seven planned rate hikes this year. That will likely increase pressure on short term rates, increasing interest rate volatility and potentially causing inversions.
So what’s this mean for investors?
“First, don’t get lost in the news,” Chang advises. “Yes, a recession is probably out there somewhere, but don’t get too focused on it. Second, the next recession won’t be anything like the last two, the pandemic recession or the financial crisis. The drivers are completely different.”
Chang predicts the next recession will likely be “comparatively mild” and akin to those of the early 1980s and 1990s. Comparatively low unemployment and high household savings will likely mitigate inflationary pressure in part.
But “the key economic drivers investors need to factor into their strategies are inflation risk and interest rate risk,” he says. “That means focusing on real estate that can increase revenues to keep up with inflation and using fixed rate debt. Those basic guidelines should help mitigate risk.”