Does the U.S. Treasury yield curve indicate an economic recession?

Over the past 12 months, the U.S. Treasury yield curve has steepened and moved out of an inverted state (i.e., yields below 0%). An inverted Treasury yield curve is often seen as a recession signal, steepening before recessions on several occasions in history, such as before the global financial crisis in late 2007, before the dot-com bubble burst in early 2001, and before the Great Depression of the 2030s. However, in most cases, the economy entered a recession within 12 months of the yield curve steepening, but as of the steepening that began in mid-2024, there has not yet been a recession. Real GDP growth in the United States has remained at 2% per annum, and the unemployment rate has remained at 4.2%, which is within the full employment range defined by the Federal Reserve System. The stock market is close to all-time highs, just a few percentage points lower, which is not in line with the typical performance of a recession.

One viewpoint suggests that economic data may soon reverse, GDP growth may decline, unemployment may rise, and the stock market may fall. Another viewpoint holds that the yield curve may not have effectively predicted the recession this time. To analyze this, it is necessary to explore why the yield curve is often regarded as a reliable indicator of economic recession.

When the yield curve inverts, short-term interest rates are higher than long-term interest rates, which is mainly influenced by the Federal Reserve's adjustments to the federal funds rate. Inversion leads to tighter credit conditions, with banks reducing loans to individuals and businesses, slowing economic growth, and potentially leading to a recession. This process usually takes 12 months. In contrast, when the yield curve is steep (short-term interest rates are much lower than long-term interest rates), credit conditions are loose, banks increase lending, and promote economic growth.

Theoretically so, but in practice it is validated through data. A line shows the rise or contraction of the US economy at any given point in time: above zero indicates growth, below zero indicates recession. The current economic growth rate is about 2%. Moving the yield curve data forward by 12 months and comparing it to the economic growth line, the two almost completely coincide. The rise or fall of the yield curve typically corresponds to the rise or fall of the economy 12 months later, demonstrating its powerful predictive ability as a macroeconomic indicator.

However, this indicator is not perfect. Historically, an inverted yield curve has occasionally not led to economic contraction, but in most cases, a recession occurs within 12 months after inversion. Since the end of 2022, the yield curve has remained inverted, but the economic performance has still been robust. We are currently in a "danger zone" because the yield curve was still inverted a year ago, indicating that the economy may slow down in the coming months. It won't be until October 2024 that the yield curve starts to steepen and escapes inversion, so recession signals may still be effective until October 2025, and the next 5 months will validate whether this signal fails.

In order to determine whether a recession is likely in the next five months, it is necessary to analyze why the economy has avoided a recession so far. One reason is that at the end of 2022, when the yield curve inverted, the U.S. job market was extremely strong, with far more job openings than in the previous 20 years and hiring activity was buoyant, unlike the weak job market in 2008 and 2001 before the recession. Job vacancies have fallen by 30% since 2022, the job market has weakened, and the economy is more vulnerable to recession than it was a few years ago, but overall it is still better than it was before the pandemic.

The second reason is that corporate profit margins are extremely high, reaching historical peak levels, which is contrary to the usual decline in profit margins before a recession. Historically, corporate profit margins have declined before recessions due to various factors, such as the oil crisis and rising interest rates in the 1970s, the bursting of the tech bubble in 1999, the bursting of the real estate bubble in 2006, and rising oil prices. Currently, corporate profit margins have not shown a significant decline, and although they may peak by the end of 2023, they remain at a high level. Certain policies, such as tariffs, may squeeze profit margins and trigger a recession, but the currently high profit margins provide a buffer for the economy, allowing companies to avoid drastic cost cuts in the short term.

Based on the current data, the economy may remain stable over the next 5 months, supporting a continued rise in the stock market. However, if the data changes, the economic outlook needs to be reassessed. Real-time data tracking and strategy adjustments are crucial for understanding economic trends.