Yield curve… The yield curve is a line showing the yields (interest rates) of bonds with equal credit quality but different maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity. The yield curve is often seen as a leading indicator of recessions. While the predictive power of the yield curve is not undisputed, its ability to predict economic downturns persists across specifications and timeframes.
US 2-10 year yield spread and National Bureau of Economic Research (NBER) recession indicator comparison… NBER is an index whether the US economy is in recession in a given quarter. According to assessments by NBER, an index value equal to one indicates a recession, and a value of zero indicates a quartile expansion. The narrowing of the 2-10-year (short-long term) spread indicates that the yield curve has flattened, while its negative turn indicates an inverse slope. Source: Bloomberg, NBER
The position of the yield curve and the recession relationship… Investors' expectation that short-term interest rates will decrease in the future leads to a decrease in long-term returns and an increase in short-term returns, leading to a flattening and even reversing of the yield curve. It is perfectly rational to expect interest rates to fall during recessions. Historically, an inverted yield curve has been seen as an indicator of a pending economic recession. When short-term rates exceed long-term rates, market sentiment suggests that the long-term outlook is weak and long-term fixed yields will continue to decline.
Interest rates usually fall early in a recession, then rise as the economy recovers. It has been observed that the yield curve slope has become negative before every recession since the 1970s. In other words, the "inversion" of the yield curve, where short-term interest rates exceed long-term rates, is typically associated with a recession in the near future. Traditionally, a flat or inverted yield curve warns of a recession about 12 to 15 months in the future.
Federal Reserve… The Fed would never want to start a recession because the primary task of monetary policy is to keep the economy strong. But the Fed's main task right now is to reduce inflation. As inflation rises, the Fed is likely to raise short-term interest rates. Despite the uncertainty arising from the Russian invasion of Ukraine, the FOMC is expected to start monetary tightening with a 25 basis point rate hike at this week's meeting.
Conclusion? An inverted yield curve occurs when the yield curve has a 'down' slope. This means that the yields on short-term bonds exceed the yields on long-term bonds. For example, if the 2-year yield exceeds the 10-year yield on U.S. Treasuries, the yield curve is inverted. A steeper curve typically indicates stronger economic activity and rising inflation expectations and therefore higher interest rates. An inverted yield curve, or spread contraction, has signaled every U.S. recession since 1970. If the yield curve is inverted and the long-term yield is lower, this may indicate a recession in the economy.
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