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Understanding the Yield Curve: How It Signals a Recession Thumbnail

Understanding the Yield Curve: How It Signals a Recession

An inversion in the bond yield curve is frequently cited as an early indicator that a recession could be looming. In the context of an inverted yield curve, we're talking about a situation where yields on short-term bonds exceed those on long-term bonds, which is an abnormal condition. Typically, investors receive higher returns for committing their capital for longer periods. When these dynamics reverse, it's often interpreted as a sign that market participants are worried about the economy's prospects.

The relationship between the 10-year and 2-year Treasury Notes, widely regarded as a reliable predictor of an upcoming recession, has been inverted for over a year. While this inversion is often seen as a precursor, the onset of a recession typically coincides with or follows the yield curve's return to a steeper, more normalized shape.

The chart below illustrates fluctuations in the spread between the 10-year and 2-year Treasury Note yields. Gray vertical bars mark recession periods over the last forty years. As you can see, each recession was preceded by a yield curve inversion, signified by the spread dipping below zero. The yield curve then steepens and normalizes, coinciding with or just before the onset of the recession.

The pattern of the yield curve first inverting and then steepening signals that a recession might be on the horizon, but it isn't a guarantee. Conditions that have preceded previous recessions are currently taking shape. My view is that the U.S. will enter a recession in the first half of 2024. The length or severity is difficult to forecast, but being aware of the possibility can help us make less emotionally-driven financial decisions should the economy slow. Now would be a prudent time to take stock of your personal financial situation and be prepared.

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