Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 272

What does the shape of the yield curve tell us?

The financial press is awash with stories highlighting the correlation between yield curve inversions, in which yields on long-term US government securities fall below the yields on short-term government debt, and recessions. So as an investor, once the curve inverts you’d probably want to underweight equities and overweight Treasuries, right? After all, since 1929 in the US, the S&P 500 Index has declined an average of 33% during recessionary pullbacks, and interest rates usually fall during recessions.

If it were only that simple

Over the past 60 years, while the curve has inverted in advance of every recession, recording only one false positive, the subsequent onset of recession has sometimes taken years to unfold. For instance, the US economy didn’t fall into recession until about two and a half years after US 10-year Treasury note yields first fell below 2-year note yields in mid-1998. And during that stretch, which included the dot-com bubble, the S&P 500 advanced more than 40%. Clearly, knowing a recession is coming and timing its arrival are two very different things.

Getting the timing wrong can be ruinous, and complicating the equation is the fact that, historically, the curve can invert, uninvert and reinvert again several times preceding recession. For instance, ahead of the 1990 recession, the 2s/10s Treasury curve inverted off and on for over a year. Which of the many inversion signals should investors have focused on? It’s tough to say.

Not your father’s yield curve

Typically, yields on longer-dated bonds, such as 10-year US Treasury notes, are greater than on shorter maturity bills and notes since investors demand to be compensated for locking their money up for longer. But these days, the spread between short-term and longer-term Treasuries is quite narrow. And if the yield curve continues to flatten at its current rate, it won’t be too many more months before the 10-year Treasury note yield falls below the yield on the two-year note. But given years of extraordinary central bank intervention in global bond markets, does today’s yield curve send the same signal as it did in earlier business cycles? We’re not sure it does.

Source: Bloomberg as of 31 August 2018. Click to enlarge.

What causes curves to flatten and sometimes invert? Usually, tighter monetary policy from the US Federal Reserve, since the effects of Fed tightening are much stronger on the short end of the yield curve than on the long end. And flattening of the curve and inversions tend to happen at the end of cycles as the Fed tightens. And cycles, by definition, end in recessions. But it’s a leap of logic to suggest that curve inversions cause recessions. In our view, while there is a correlation there isn’t necessarily causation.

And even if there has been causation in the past, we’d be mindful of Goodhart’s law: When a measure becomes a target, it ceases to be a good measure. In other words, when market participants — including the Fed — become laser-focused on something like the shape of the yield curve, it may no longer be a useful metric.

What’s different this time?

This business cycle is unique when compared with other post-World War II cycles. For starters, our present cycle has been influenced by the Fed’s use of quantitative easing, which resulted in a ballooning of its balance sheet. Many would reason that this build-up, from roughly 5% of GDP prior to the GFC crisis to a peak of nearly 25% of GDP in 2014, has changed the traditional dynamic when it comes to curve inversion. The Fed’s massive asset purchases appear to have reduced term premium, the excess yield that investors demand to commit to holding a long-term bond instead of a series of shorter-term bonds. Fed economists estimate that long-term rates may be 0.75%–1.00% lower today than would otherwise be the case absent the larger-than-normal balance sheet. Some contend that accounting for the amount of quantitative easing and its dampening impact on term premium, the curve would have to invert by 50 to 100 basis points before it would provide the same signal of a subsequent recession as in the past.

That said, each business cycle since the 1980s has displayed unique characteristics with regard to term premium, so we’re not convinced a term-premium-based argument concerning curve inversion is particularly useful in timing the onset of recessions.

Another unique feature of this cycle is that nominal rates are much lower than in prior cycles, so a yield curve inversion may provide a different signal than it did in the past. Some would argue that it’s more difficult to invert the curve when yields on the front end (two years and shorter) — despite rising over the past few years — are still historically low. To illustrate, Japan’s economy, with its super-low interest rates, hasn’t experienced curve inversions ahead of recessions since 1991, though it has fallen into recession seven times since that year.

An additional oddity of our present cycle is that not all sections of the yield curve are behaving similarly. Indeed, the short-end of the curve — from federal funds out to two years — steepened while the more closely-watched 2-years/10-years curve has flattened. We’d be more worried about recession if both curves were inverted. The fed funds/2-years curve is particularly important to the banking system as that part of the curve is where banks make much of their money. Should it invert to the point where banks are paying out more on short-term deposits rates than they are taking in on 2-year loans, the flow of bank credit would likely dry up, constraining economic growth.

Watch the macro

So if investors can’t reflexively rely on the slope of the yield curve to help guide asset allocation, what should they watch? In our view, they should keep a close eye on macroeconomic data. High-frequency data such as purchasing managers’ indices, non-farm payrolls and initial jobless claims, taken together, can help guide decision making more holistically than relying too heavily on a single indicator. These sorts of macro indicators would be good signals to gauge whether the Fed is expected to become overly tight, pushing front-end rates too high, and ultimately resulting in a recession.

 

Erik Weisman is Chief Economist and Portfolio Manager at MFS Investment Management, a sponsor of Cuffelinks. The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.

For more articles and papers from MFS Investment Management, please click here.

 

RELATED ARTICLES

The seeds of a downturn, and opportunity

From macro to micro: end-of-cycle investing

Recession and why timing markets doesn't pay

banner

Most viewed in recent weeks

Simple maths says the AI investment boom ends badly

This AI cycle feels less like a revolution and more like a rerun. Just like fibre in 2000, shale in 2014, and cannabis in 2019, the technology or product is real but the capital cycle will be brutal. Investors beware.

Why we should follow Canada and cut migration

An explosion in low-skilled migration to Australia has depressed wages, killed productivity, and cut rental vacancy rates to near decades-lows. It’s time both sides of politics addressed the issue.

Are LICs licked?

LICs are continuing to struggle with large discounts and frustrated investors are wondering whether it’s worth holding onto them. This explains why the next 6-12 months will be make or break for many LICs.

Australian house price speculators: What were you thinking?

Australian housing’s 50-year boom was driven by falling rates and rising borrowing power — not rent or yield. With those drivers exhausted, future returns must reconcile with economic fundamentals. Are we ready?

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Welcome to Firstlinks Edition 627 with weekend update

This week, I got the news that my mother has dementia. It came shortly after my father received the same diagnosis. This is a meditation on getting old and my regrets in not getting my parents’ affairs in order sooner.

  • 4 September 2025

Latest Updates

Shares

Why the ASX may be more expensive than the US market

On every valuation metric, the US appears significantly more expensive than Australia. However, American companies are also much more profitable than ours, which means the ASX may be more overvalued than most think.

Economy

No one holds the government to account on spending

Government spending is out of control and there's little sign that Labor will curb it. We need enforceable rules on spending and an empowered budget office to ensure governments act responsibly with taxpayers money.

Retirement

Why a traditional retirement may be pushed back 25 years

The idea of stopping work during your sixties is a man-made concept from another age. In a world where many jobs are knowledge based and can be done from anywhere, it may no longer make much sense at all.

Shares

The quiet winners of AI competition

The tech giants are in a money-throwing contest to secure AI supremacy and may fall short of high investor expectations. The companies supplying this arms race could offer a more attractive way to play AI adoption.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Infrastructure

Renewable energy investment: gloom or boom?

ESG investing has fallen out of favour with many investors, and Trump's anti-green policies haven't helped. Yet, renewables investment is still surging, which could prove a boon for infrastructure companies.

Investing

The enduring wisdom of John Bogle in five quotes

From buying the whole market to controlling emotions, John Bogle’s legendary advice reminds investors that patience, discipline, and low costs are the keys to investment success in any market environment.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.