Why the Longest-Ever Yield Curve Inversion Isn’t Troubling

Yield curve inversions—when short-term interest rates top long—have a pretty reliable record of signaling forthcoming recessions. But this time, US yield curve inversion is staring down its second birthday with no recession in sight, leading many to question its predictive powers. While the subject is worth exploring, we think the discussion misses some key points for investors.

US 3-month yields have topped the 10-year since October 2022, a 20-month inversion that ranks as history’s longest. Yet the recession most expected around then hasn’t arrived.

Exhibit 1: Yield Curve Inversion Typically Signals Recession

Source: FactSet, as of 6/5/2024. 3-month and 10-year Treasury yields, 1/4/1954 – 6/5/2024.

We think this makes an important point super clear: Inversion isn’t a timing tool. 2022’s bear market occurred as the yield curve flattened, but this flattening didn’t say anything stocks weren’t already pricing in. Inversion roughly coincided with October 2022’s bear market low—and a new bull market beginning. So to the extent it signaled elevated recession risk, there was strong evidence stocks had already priced it. The inverted curve also got heaps of attention, likely sapping any surprise power. Stocks have since rallied throughout the long inversion—to record highs even.

So, why hasn’t yield curve inversion preceded recession (at least, so far) when it has done so many times before? Historically, inversions signaled credit contractions, which raise the risk of recessions. The spread between short and long rates usually reflects new lending’s profitability—banks’ net interest margin. As banks borrow short (paying interest on your deposits) and lend long (collecting interest on the loans they make), a narrowing spread would ordinarily make banks less eager to extend credit. That would mean less new capital to fuel investment.

But not this cycle. As the Fed hiked rates, bank deposit rates stayed ultra-low thanks to a deposit glut. Banks didn’t have to compete with higher rates. While that is changing to a degree, the average rate banks pay on savings deposits nationally has risen to all of 0.45%—their funding costs remain extremely low, far below what 3-month Treasury yields’ 5.37% implies.^[i] Meanwhile, benchmark 10-year Treasury yields currently stand at 4.28%—with banks’ loan rates far higher.^[ii] For example, the prime loan rate (the reference rate for short-term business loans) is 8.5%, while the average 30-year fixed mortgage is 7.0%.^[iii] No wonder, as Exhibit 2 shows, total bank credit keeps expanding, unlike 2009’s contraction.

Exhibit 2: Bank Lending Continues Making Record Highs

Source: Federal Reserve Bank of St. Louis, as of 6/5/2024.

Now, bank lending has slowed from over 12% y/y in 2022 to 2.3% through May.^[iv] Commercial and industrial loans dipped negative on a year-over-year basis in October 2023 and are basically flat today. High rates have impacted demand in areas more reliant on bank lending. This helps explain real estate’s struggles, manufacturing’s downturn and the pullback in equipment investment. So while the inversion did presage some weakness, it wasn’t widespread enough to cause a recession.

We see a couple reasons for this. One, the inversion was widely discussed and dialed up recession expectations. A recession’s primary purpose, typically, is to squeeze excess from the economy. Companies usually get caught flat-footed and have to make severe cuts when trouble strikes. This time, businesses, seeing the inversion and universal recession forecasts, didn’t wait for concrete signs of trouble. They cut excess proactively to ride out anticipated lean times. We think their anticipation ended up mitigating the recession that might otherwise have forced them to cut back more severely. Meanwhile, growth sectors remained able to self-finance expansion, using their flush balance sheets to fund profitable projects even as they shrank more bloated business units.

However, just because inversion isn’t working now, doesn’t mean it won’t in the future. Primarily, we think it depends on how accurately the yield curve represents banks’ new loan profit margins and the impact that has on overall credit flowing through the economy. Even this time, a recession could strike if credit contracts. Again, inversion isn’t a timing tool. A lag this long would be unusual, and recession doesn’t look likely, but being mindful of the possibility is important.

We also see longer-term implications. Typically, the more coverage an indicator receives, the less effective it is—it gets too well known and priced in. According to Factiva, 2019’s and 2022’s inversions prompted more than twice 2006’s major financial press mentions.^[v] People were on the lookout for inversion. That might not happen in the future, especially if it doesn’t work now. Many may conclude it is broken and move on.

This could give it more power in the future. We might be seeing the seeds of this now. Pundits are starting to suggest inversion’s lack of negative impact heralds a (new) new economy where America’s services sector is big and stable enough to overcome problems caused by an inverted yield curve in other credit-sensitive parts of the economy—rendering the yield curve an antique with no modern relevance. If that notion becomes more widespread, it could set investors up to dismiss future inversions, giving it surprise power once more.

At present—and properly understood—yield curve inversion remains benign. But this could change. In our view, that means investors also need to be aware of its broad misperceptions and how they diverge with actual credit conditions.