Can the Yield Curve Predict Recessions?

The shape of the yield curve tells you what bond investors think about the future direction of the economy. The yield curve is a graphic representation of bond yields at different maturities.

As compensation for locking up your money for a longer time period and taking on greater inflation and interest rate risk, long-term bonds typically yield more than shorter-term ones. As a result, under “normal” economic and market conditions, the yield curve points up; that is, yields rise as we move out the curve in terms of maturities.

What Does the Yield Curve Look Like Now?

Currently, the yields on the one-year Treasury note and three-month Treasury bill are around 4.7%, while the benchmark 10-year note yields just 3.6%.

This means that the yield curve is inverted and pointing down as sharply as it has at any time in the last 40 years or so.

Yield Curve Inversions Precede Recessions

The yield curve's current shape is important because research from the Federal Reserve Bank of St. Louis* indicates that the one-year/10-year yield curve inversion has preceded each recession in the last 50 years by about one to two years. Meanwhile, the three-month/10-year yield curve inversion has preceded recessions by 13 months or less.

The one-year/10-year and three-month/10-year yield curves have been inverted since July and October 2022, respectively. This certainly suggests that bond investors believe the economic trajectory is downward. And if that historical relationship holds, then we’re likely looking at a recession before 2023 is out.

Other Bond Market Expectations

Similarly, Federal funds futures (FFFs, futures contracts based on the federal funds rate), which capture bond market expectations for future interest rate policy, are consistent with this recessionary view. At present, FFFs are now fully discounting another 25-basis point hike at the March Federal Open Market Committee (FOMC) meeting. They also show a high probability of another 25-basis point hike in May or June.

That means the market expects the terminal or “peak” rate to come in at slightly over 5%. That is in agreement with the Federal Reserve’s (Fed’s) “dot plot” forecast of future rate hikes. It is also consistent with our own interpretation of Fed governors’ recent comments.

Interestingly though, FFFs also indicate that the market is expecting at least one or perhaps even two Fed rate cuts in the back half of 2023. This is the “pivot” that so many in financial markets expect this year.

Nevertheless, such a pivot remains antithetical to the position taken by the Fed in its commentary and recent speeches. This highlights the disconnect on the path of future monetary policy between the markets and the Fed.

But it should be clear that the bond market’s own view is consistent: Both the yield curve and FFFs appear to be pointing to a recession and presumptive Fed response before the year is out.

Our View: Yes, Recession Remains Likely

We think a recession is likely based on our reading of some key recession indicators:

• Housing data remain weak, as measured by prices, sales, mortgage applications, building permits and housing starts.

• Manufacturing activity captured in the ISM Manufacturing Purchasing Managers' Index contracted for a third straight month in January, falling to the lowest level since the depth of the COVID-19 recession.

• Regional manufacturing reports are almost uniformly negative over the last several months.

• Month-to-month retail sales were down in four of the last six months through December 2022.

• Corporate earnings as reported by companies in the S&P 500® Index about halfway through the fourth-quarter earnings season are negative. If earnings growth is negative for the full quarter, that would be the first year-over-year decline in earnings since the third quarter of 2020. Forward earning projections for 2023 are barely positive.

• Yield curve inversion, as we’ve discussed above, began in mid-2022.

• Debt levels are already high coming into this slowdown, which limits the ability of the government to intervene to support the economy. Household debt as a percentage of gross domestic product (GDP) is, however, fairly healthy when compared with the high debt levels associated with the Great Financial Crisis.

This is the textbook recipe for a recession, and it’s why we believe it’s still too early to commit to what we consider to be a bear market rally (a brief rally in the context of a larger market decline). We believe these fundamentals argue for continued volatility in equities despite the market’s hyper-focus and expectation of an early Fed policy pivot.

How We’re Positioning Our Portfolios for a Coming Recession

Our cautious economic outlook is influencing our portfolio positioning. The fundamental economic outlook above means we think we will benefit from conservative positioning entering 2023.

This view is reflected in our multi-asset portfolios’ positioning around our long-term strategic allocation targets.

Because we view the current risk-on rally as a bear market rally, we would characterize 2023 as something akin to “in like a lion, out like a lamb.” We could imagine a sustained turn in financial markets ahead, but we believe we have to work through the difficult economic conditions and presumed recession first. Then we can begin to contemplate a sustained, new bull market in equities.