An inverted yield curve, as measured by the difference between short- and long-term Treasury yields, has historically been a reliable indicator of recession. When short-term rates, which are more heavily impacted by central bank policy, become higher than long-term rates, which are more closely tied to economic growth and inflation expectations, a recession has typically followed within 12-18 months (see our blog for more insight).
While the overall Treasury yield curve remains far from inverted; the short end of the curve, specifically the 3- to 6-month segment, inverted on July 20. What does this mean for markets moving forward?
The short answer is: Not much. As the chart below shows, inversion in the 3- to 6-month segment of the yield curve is not an uncommon event. There have been times when an inversion in this part of the curve occurred prior to or during a recession, but there are also plenty of instances when it happened during periods of strong growth.
One such instance in the mid-1990s may relate to the recent inversion. In late 1995/early 1996, a debate about whether to raise the government’s debt ceiling ultimately led to a government shutdown. As we can see from the chart, the short-end of the Treasury curve inverted starting in late May 1995, and continued to bounce in and out of inversion until March 1996, two months after the shutdown ended.
The broad consensus with respect to the latest inversion is that it too is tied to potential worries around the debt ceiling, which the Treasury expects will be reached in mid-October should it not be raised. That would be roughly three months from the date that the yield curve first inverted (7/20/2017, following a 3-month Treasury auction), though the curve has since normalized (inversion stopped on 7/26/17, one day before another 3-month Treasury auction on 7/27/17). This doesn’t necessarily mean that markets don’t foresee a potential debt ceiling debate, but it does indicate that the latest inversion in the Treasury curve was more likely driven by political, rather than economic, concerns.