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Treasury Yield Curve: Is It a Reliable Recession Indicator?

Treasury yield curve was long considered a reliable leading indicator of recession. The treasury yield curve is a graph of treasury bond interest yields vs. maturity period. In growing stable economic conditions, long term interest rates are set higher than short term interest rates, thus compensating the investors for the additional risk.

Treasury yield curve
Treasury yield curve: March 2003.

The treasury yield curve is routinely used as a market indicator, expressing expectations of market participants about the future. Whenever the recession is approaching, the investors and traders are expecting easing of the Federal Reserve monetary policy, and, as a result, reduction of interest rates. Such expectations first influence the long term bonds, driving their price up and thus reducing long term interest rates and flattening the treasury yield curve. At the same time, the drive for capital due to financial problems may boost the short term interest rates, which is reflected in short term treasury bond yields. If the long term interest rates drop below short term interest rates, we may observe inversion of the treasury yield curve. The inversion means that the market is expecting drop in short term interest rates in the future, and drop in short term interest rates is a sign of recession.

Treasury yield curve
Inverted treasury yield curve before recession: March 2007.

The current interest rates are so low, that the long term interest rates should drop almost to zero for the curve to invert and it’s highly unlikely. We can see signs of flattening of the treasury yield curve, that is a sign of coming slowdown. But we have a good chance of missing the recession warning if we wait for the treasury yield curve to flatten or invert.

Treasury yield curve
Treasury yield curve: July 2015 and February 2016.

See also:

Why a Recession Could Arrive Without a Yield Curve Warning