In 1973, the inversion of the yield curve happened 8 months before the recession. And before the crisis of 2007 — two years before it began, and by the time of the collapse of the financial markets the yield curve in this area acquired a normal appearance.
If you look at the difference in yields of ten-year and two-year securities, it is possible to conclude that a negative value speda really preceded all recessions over the last 40 years with a lag of not more than 24 months.
Figure 1. The spread between yields on 10-year and 2-year United States Treasury securities. Gray color designates the periods of recession:
This phenomenon still causes a lot of disputes and discussions. However, to assert that the inversion foretells recession — still not worth it. Let’s try to understand this question.
Most studies of the yield curve refer to nominal interest rates. In reality, however, in economic theory an important role is played by the real (inflation-adjusted) interest rates.
According to the theory of asset pricing, the real interest rate measures the rate at which consumption is expected to grow over time. High annual yield indicates a high expected growth on the horizon of one year. A decade of high profitability signals high expected growth on the horizon 10 years. If the difference between ten-year and two-year yield is positive, is expected to accelerate the growth of consumption, if negative —the slowdown.
How does this idea correspond with macroeconomic data? The figure below shows the actual spread of the ten-year and annual returns along with the rates of growth of real consumption per capita per year.
As can be seen from the figure, the real yield curve indeed flattened and inverted before each of the last three recessions, which occurred when consumption grew at a moderate or slow pace.
At the same time, and the consumption growth tends to slow down as the leveling of the yield curve. This is true even not in times of crisis. In particular, the slowdown of consumption in 1985-1986, 1988-1989 and 2006-2007 was accompanied by a significant reduction or shift in the negative value of the spread of returns of securities.
Now remember that the beginning of past recessions has always been associated with certain events. In 1990, the invasion of Kuwait by Iraq which resulted in the jump in world oil prices. The reason the last two recessions in 2001 and 2007 were the falls in prices on the financial markets. It is unlikely that the timing of these events could be predicted using the curve.
Thus, the inverted yield curve does not predict a recession. Rather, it predicts economic conditions that make a crisis more likely.