At the beginning of April, the 10-2 year yield curve briefly inverted, creating widespread hysteria in the financial media. However, despite what you may have been hearing or reading, an inversion of the 10-2-year yield curve does not necessarily mean that a recession is imminent. Historically, a 10-2-year yield curve inversion has provided one of the earliest warning signals, sometimes preceding a recession by as long as 2 years and 10 months. And as we have shown in a prior note, stocks can perform quite well for some time following an initial inversion. As such, we will need to see more evidence fall into place before we can confidently determine that it is time to prepare for a recession.
One confirming piece of evidence that we will be watching closely is whether the inversion of the 10-2-year spread begins to extend to other maturities along the curve. The indicator shown in blue in the chart below measures the percentage of all yield spreads ranging from 1 month to 10 years that is inverted. Based on our research, we found this indicator to be a more reliable recession forecasting tool than the yield curve itself. Historically, no recession has ever occurred without 80% or more of the curve being inverted first, with a recession occurring 10 months later on average. Today, after a brief spike to just below 20% at the beginning of April, the indicator has fallen down to 5% thanks to the re-steepening of some parts of the curve, including the infamous 10-2-year spread. With the shorter segments of the curve still at very steep levels, it could take some time for this indicator to cross above 80%. Until then, recession risk remains low.
Sauro Locatelli CFA, FRM™, SCR™
Director of Quantitative Research
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