It happened. The yield curve inverted. The big one. The 10-year Treasury bond rate dropped below the 3-month Treasury bill rate. That’s the inversion that economists think is the most reliable indicator of a coming recession.
Yield curve inversions have happened before each of the last seven recessions. During the past 50 years, every time the yield curve inverted a recession started within in 5 to 16 months. Our inversion first happened on May 23, so it’s predicting the start of a recession sometime between October 2019 and September 2020.
Why does the yield curve invert, and why does it predict a coming recession? Normally, investors get higher yields on long-term bonds. They’d rather not tie their money down for 10 long years. Better to lend for 90 days and get the money back, to reinvest or spend as needed. So the government has to pay higher interest rates to get investors to lend long-term.
Inflation erodes the value of interest payments on loans. Over three months we’ve got a really good idea what inflation will be. Over 10 years, not so much. The government must pay more interest to get lenders to make more risky long-term loans.
Now suppose investors think interest rates will fall. If they lend for only 90 days, they’d have to reinvest at a lower interest rate. Better to lend for 10 years, and lock in the current higher rate. So, when interest rates are expected to fall, money flows to long-term bonds. The government doesn’t have to pay as much to borrow. They have to pay more for short-term money instead. The yield curve inverts.
When do lenders expect yields to fall? When inflation is expected to fall, or when the Federal Reserve is expected to cut interest rates. Those things usually happen in recessions.
The yield curve inverts when investors think a recession is coming. For the past 50 years they’ve been right, every time.
But what about before that? Go back 53 years, to Jan. 12, 1966. The yield curve inverted, but a recession did not follow in 5 to 16 months. In fact, a recession didn’t start for almost 4 years, and before that the yield curve righted itself, then inverted again.
Here’s the story. President Lyndon Johnson had pushed Congress to cut taxes, so consumer spending was increasing. Congress was passing the president’s Great Society programs — Medicare, Medicaid, food stamps and many more. And the U.S. was escalating the war in Vietnam. Government spending was rising.
Added spending was increasing inflation. The inflation rate had crept up from 1 percent at the start of 1965 to 2 percent by the end of the year. Rising inflation concerned the Federal Reserve, so in December 1965 it hiked the policy interest rate a full half-point.
President Johnson was furious. He summoned Fed Chair William McChesney Martin to his ranch in Texas and raked him over the coals. He had members of Congress threaten hearings. Sen. William Proxmire called the rate hike a blunder that could end the ongoing 58-month expansion.
That’s when the yield curve inverted.
Throughout 1966 Martin wouldn’t budge, but in February 1967 the Fed relented and reduced interest rates. The president had offered to raise taxes to take the edge off all that spending.
The tax proposal was unpopular, and Johnson couldn’t get it passed until mid-1968. That period of low taxes, high spending and low interest rates helped push the inflation rate to 6 percent by the end of the decade, on its way to double-digits in the 1970s.
But there was no recession in 1966 or ’67. Perhaps the Fed’s interest rate reversal caused the yield-curve inversion to miss its prediction.
The Fed increased interest rates from December 2015 to December 2018, trying to stop inflation before it started. The president pressured the Fed to stop raising rates, and financial markets got jittery. In 2019 the Fed relented. It all sounds familiar.
Yield curve inversions are reliable predictors of recession. We should be alert to the possibility of a downturn later this year or next. But yield curve inversions are not destiny. If the Fed changes its policies, the prediction may be wrong. Remember 1966 — and hope history repeats.
Larry DeBoer is professor of agricultural economics at Purdue University.