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What Is Yield Curve Inversion and How Does It Predict a Recession?


Right now, investors are grappling with a good deal of economic uncertainty thanks to interest rate hikes, inflation and global supply chain hiccups, among other things. As a result, the threat of yield curve inversion is top of mind. The spread between 10-year and 2-year Treasury yields continues to shrink, furthering recession fears.

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So, what is yield curve inversion and why should you care about it?

Well, under normal economic circumstances, 10-year Treasury bonds should always yield a greater return than more short-term Treasurys, like 2-year bonds. However, under abnormal market conditions, the spread, or difference in return, between short- and long-term Treasurys tends to shrink. In particularly uncertain or bearish times, the Treasury yield curve will even invert, reflecting that short-term bonds have higher returns than long-term Treasurys. In fact, Treasury yields have inverted prior to every U.S. recession since World War II.

As you might imagine, the current economic predicament has led investors and analysts to closely watch yield curves as an indicator of an impending downturn. Some analysts have even started predicting a yield inversion as a consequence of rising prices and interest rates. Reasonably so, as the current spread between 10-year and 2-year Treasurys is 0.21%. For context, the value was around 0.85% at the start of the year.

So, does the threat of a yield curve inversion suggest a recession is on the way?

Goldman Sachs Predicts Yield Curve Inversion on Way

This morning, Goldman Sachs increased its prediction for future Treasury yields. The investment bank believes 2-year yields will rise from 2.29% to 2.9% by the end of the year, and to 3.15% by the end of 2023. Goldman also raised its prediction for 10-year yields, projecting them to reach 2.7% this year. Goldman’s increased prediction stems from expectations that the Federal Reserve will further hike interest rates in the next few months.

While rising Treasury yields present a slightly different concern than yield inversion, Goldman also believes the 2-year and 10-year yields will likely invert this year.

“One feature of our forecast is a modest inversion of the 2s10s yield curve by year-end. However, we note that the nominal curve tends to invert more easily in a high inflation environment, and we could see earlier and/or deeper curve inversions this cycle. In such an environment, a deeper nominal curve inversion may be needed to produce the same recession odds in models as seen in more recent business cycles.”

While Goldman predicts a yield curve inversion, it doesn’t foresee it being of the same depth as previous inversions. Indeed, the bank believes that a more pronounced inversion is necessary to indicate a recession.

Whether or not the curves invert, or the inversion results in a true recession, remains to be seen. Rest assured, analysts and investors will be keeping a close eye on Treasury yield spreads going forward.

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

With degrees in economics and journalism, Shrey Dua leverages his ample experience in media and reporting to contribute well-informed articles covering everything from financial regulation and the electric vehicle industry to the housing market and monetary policy. Shrey’s articles have featured in the likes of Morning Brew, Real Clear Markets, the Downline Podcast, and more.

Article printed from InvestorPlace Media, https://investorplace.com/2022/03/what-is-yield-curve-inversion-and-how-does-it-predict-a-recession/.

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