Earlier this week, the yield curve briefly inverted, with the 10-year treasury yield dipping below the 2-year yield. Such inversions have preceded every recession in the U.S. over the past 50 years by around two years on average. However, it probably isn't worth making big changes to a portfolio based on this news. 

Even if the yield curve is a good predictor that a future recession will happen, it isn't a great predictor of precisely when it will happen. Stocks often continue to march upward between the time the yield curve inverts and the start of a recession. 

But perhaps more importantly, this is not a normal interest rate environment, so an inverted yield curve may be a less useful predictor of recession risk now than it has been in the past. One of the reasons the shape of the yield curve has been a good predictor of recession risk in the past is that it reflects investors' expectations of future short-term rates and investors expect rates to fall during a recession, as the Fed seeks to stimulate the economy. 

The Fed recently cut rates to get ahead of recession risk and signaled a willingness to continue to do so, even though there are signs the economy doesn't really need the boost. Interest rates abroad are also low--in fact, they're negative in the eurozone, which can increase demand for U.S. treasuries and depress rates in the U.S.

While the yield curve is influenced by expectations of future short-term rates, it is also influenced by the term premium, which is the compensation investors require for accepting longer-term bonds higher interest rate risk. That term premium isn’t directly observable, but an econometric model developed by economists at the New York Fed suggests that it has become negative in recent years. This makes it easier for the yield curve to invert even when investors expect short-term interest rates to rise slightly. So, the market may not be pricing in rate cuts after all.

Sam Lee, the former editor of this newsletter, wrote a good blog post about this in April. We’ll tackle interest rates in the October issue.

Best,

Alex