Monday, November 27, 2023

The inverted yield curve is starting to resemble the tale of “The Boy Who Cried Wolf.”

The yield curve is the difference between long- and short-term interest rates, often the 10-year and three-month U.S. Treasury yields. Normally, long-term rates are greater than short-term rates because your money is tied up longer and having long-term yields eclipse short-term yields encourages longer duration lending. That’s good for growth.

But when short-term rates rise above long-term rates, investors aren’t paid to take risk in longer-term bonds. The yield curve turns negative, or inverts. This brings less reason to invest in the future, so the economy slows. That’s why the yield curve tends to invert ahead of recessions.

It’s the world’s best recession indicator, and it started flashing in October 2022. Murmurs of a recession began months before, but once the curve inverted, recession essentially became the consensus. But it hasn’t happened.

Still, this indicator flashed daily since last October, the longest stretch in the signal’s history. In fact, today’s inversion has eclipsed the 217-day streak we saw in 2006-07, right before the worst recession of our lifetime. The current streak is now the longest one, and there are no signs of it ending soon.

This is quite confusing because an inverted yield curve is widely regarded as one of the most reliable signs of trouble. But after a year of flashing with no recession to speak of, it’s starting to look like the indicator that cried wolf.

The moral of the story is don’t rely on a single metric, no matter how strong its track record. Even the inverted yield curve has generated false positives. Hardly anybody expects that to be the case this time around, but it’s certainly possible.