How the Inverted Yield Curve Reliably Predicts Recessions.

It's what everybody's talking about. Recession fears are rising. The spread between the two-year and the 10-year bond officially inverted for the first time since 2019, a sign that a recession could be on the horizon. It's predicted every recession, recession, recession, recession, recession in the past half century. As you guys know, on this channel, I am not about trying to predict recessions. I'm not about trying to time the market. You know, as they say, time in the market beats timing the market.

But quite bizarrely, there is one rather common market metric that has predicted every single recession over the past 50 years, and right now it's flashing red once again, the first time it's done so since 2019. So what is this mysteriously reliable indicator of recessions? Well, it's the inversion of the treasury bond yield curve.

But before we get into the specifics of the yield curve itself, we have to understand the world of government bonds. So, as we know, the US government spends a lot of money. We definitely know that much is true. And when their income isn't sufficient to fund their spending, they sell a bond. A government bond is a contract between the government and an investor.

The investor loans some money to the government for an agreed length of time with an agreed annual rate of interest. It's essentially a contract written by the government, and it will say something like, "I hereby declare that you should buy this bond from this year’s government. The government will pay you a five percent interest payment every year for, say, ten years, at which time the bond will reach maturity, and we will give you back your money."

This agreement is written on the bond, and it doesn't change for the lifetime of it. So, if you invested, say, a thousand dollars into this bond, you would initially be giving the government a thousand dollars, and then each year you would receive fifty dollars in interest until the bond reaches maturity in ten years' time, at which time the government will then give you your original thousand dollars back.

Here's the tricky bit: after the bonds have been bought from the government, they are then traded on the open market. You don't have to sell your bonds; you can hold them until maturity and take that promise made to you by the government. But you may also choose to watch the present market value of your bonds, and if the market is offering you a pretty good price for them, then you might choose to sell the bonds and lock in a profit before the maturity date.

So why do bond prices fluctuate on the open market? Well, from our example above, we're outlaying a thousand dollars to get fifty dollars per year for ten years, and then we'll get our thousand dollars back. So overall, we'll have to wait for ten years to get that full promise. But what if there's clearly a better option out there for investors?

What if six months later, the government offers a five-year bond that could make you the exact same amount of money? Well, obviously, investors are going to be busy buying that fresh bond, and they're not going to be super interested in that ten-year bond that you've got. So the market price of your bonds might fall.

But here's the crazy thing: the thousand dollar bond you bought is still going to pay out fifty dollars per year for ten years, and you're still going to get your one thousand dollars back at the end of it. Initially, this means you signed up for a five percent annual return or a five percent yield. But if the bond price fell down to, say, 900 on the open market, the bond is still going to pay you fifty a year, and you're still going to get back a thousand dollars at the end of the ten years.

So this means that if investors decide to buy it at 900, they're going to get a 5.6 yield. But that's not all, because if they hold under the bond through to its maturity, they'll also get a thousand dollars back. So they'll get an extra 100. That's the story if bond prices fall.

But then, on the contrary, bond prices can also rise. If investors are finding less and less enticing options elsewhere, then your bonds are going to get more and more valuable, and their price will rise on the open market. However, as the market price rises, the yield of the bond falls because they're only ever going to pay out fifty dollars per year and then return the thousand dollars to you at the ten-year mark.

If you pay more on the open market for that deal, then that's just bad luck for you. You should have bought them hot off the press when they were cheaper and the yield was higher. So that's how bonds work, and that's why there's an inverse relationship between the price and the yield.

The next thing to know is that there are a range of government bonds out there with different interest rates and different maturities. So we can plot these out on a chart where the x-axis shows the time to maturity and the y-axis shows the interest rate, and this is called a yield curve.

A healthy yield curve will normally take this kind of shape, with short-term bonds offering a lower yield than the long-term bonds. In this scenario, investors are expecting economic growth, and economic growth, as we know, can lead to inflation, which can cause the Federal Reserve to raise interest rates. Thus, investors seek a higher yield on those bonds to accommodate this risk.

But what we've been seeing lately is a flattening of this yield curve, aka, the yield on the long-term bonds has been going down, and the yield on the shorter term bonds has been rising. So why would we see this? Well, the left-hand side of the yield curve is very much dependent on the Fed's decision regarding interest rates. If the economy is hot and inflation is high, then the Federal Reserve will raise interest rates to make borrowing more expensive to hopefully stop further inflation, and that's what we're seeing happen right now.

The Fed has already penciled in many more interest rate hikes across the next few years, so this raises the yield on the short-term bonds. But then on the other side of the chart, the yield of long-term bonds reduces because investors see trouble looming in the short term and increasingly want to lock in a set-in-stone long-term return.

So this naturally causes a lot of buying of long-term bonds. But remember, this is a yield curve, so as the long-term bonds are increasingly bought and the prices rise, the yield lowers because the T's and C's of the bond do not change. Investors are just willing to pay a higher price for the same deal; thus, the yield lowers.

Overall, that's why the yield curve flattens. It's a measure of expectation. If the future looks bright, the curve looks healthy. If the future looks sketchy, then the curve may flatten or even invert, and right now it’s certainly flattening out.

This is what the US government bond yield curve looked like six months ago, and this is where it is today. But haven't we been hearing in the media that the yield curve has inverted? That still looks like it goes up over time. Instead of looking at all of the bonds of varying maturities, a lot of investors just look at the 10-2 spread.

They compare the difference in yield between the 10-year treasury bond and the two-year. And when you do that, six months ago, we looked absolutely fine, but now it's not looking as great, pretty flat. This chart fluctuates all the time, so one day it might be flat, one day it might technically be inverted, and I don't actually know whether right now the curve will be flat or inverted.

But if we look just last week on Tuesday and on Thursday, we did see an inversion of this yield curve, which is of course the ticket that news sites needed to plaster it all over their front pages. But why should we care? And as I said at the start of the video, no one person or indicator is able to accurately predict whether a recession is on the horizon.

But weirdly, in the case of the 10-2 spread, since this chart started back in 1976, every time it dips negative, the United States has hit a recession shortly after. It's actually crazy that this literally predicted every single recession for the past 46 or so years. And because it so happens, this indicator has been very reliable.

This is the reason that economists and investors prick their ears up when they hear that right now, in 2022, it's just gone negative again. But with that said, I did just want to discuss some limitations of the 10-2 spread. Firstly, while it has guessed the past six recessions, it doesn't magically let you know how long until the next recession hits.

So sometimes it takes a few months; sometimes it takes a few years. Then another factor is that we also haven't seen a sustained period of inversion yet. As you might expect, if the spread remains negative for a longer period of time, the more likely it is for a recession to occur. But at the moment, we're just seeing momentary flutters where it's negative.

Then it's also worth remembering that this indicator is just one number, and another evidence-based recession indicator is the inversion of the three-month and 10-year treasury bond yield curve. However, if we look at that one, it's still nowhere near negative. And lastly, we have to remember that the stock market and the economy aren't the same thing.

You know, this article, which has a graph from Truest Advisory Services, shows that if you actually look at the S&P 500 returns in various time periods after the inversion of the two-year and the 10-year treasury yield curve, then the stock market returns have not been a disaster. In fact, in five instances, the S&P 500 was up double digits just 12 months after the inversion of the yield curve.

So overall that's the story of the inverted yield curve. Yes, it has been surprisingly good at predicting recessions; however, it is just one number, and it's worth remembering that it doesn't necessarily spell doom and gloom for the stock market.

Let me know your opinion down in the comments. Do you follow the yield curve in your investing, and do you think its remarkable predictive power is a coincidence? Coincidence, I think not! Or is there more to it? Also, if you'd like to learn more about inflation and interest rates, and also the money traps that they're causing specifically in 2022, then definitely check out the video coming up on the screen right now if you wanted to delve into more of that side of things.

That video will be extremely helpful for you. But apart from that, guys, leave a like on the video if you enjoyed, subscribe to see more, and I'll see you guys in the next video. This video is brought to you by Sharesight. Sick of tracking your performance manually? Track capital gains, dividends, and currency fluctuations easily, and when it comes to tax time, have everything you need ready to go with just a click of a button.

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