The Yield Curve’s “False Positive”

March’s yield curve commotion now looks like the first “false positive” of this expansion.

While a prolonged yield curve inversion, or long-term rates falling below short-term rates, has preceded economic recessions historically, quick and shallow inversions are common later in economic cycles. As shown in the LPL Chart of the Day, the yield curve typically flickers between positive and negative several times before the U.S. economy peaks, which has happened an average of 21 months after the first inversion.

The 10-year Treasury yield fell below the 3-month Treasury yield on March 22 for the first time since August 2007, fueling recession calls as investors scrambled for answers on the bond market’s cautious signaling. The spread between the two yields fell as low as -7 basis points (-0.07%) on March 27.

Since then, the 10-year yield has rebounded about 15 basis points (0.15%) amid progress in trade negotiations and improving data from China, calming investors’ nerves as the yield curve climbed back into positive territory after five days of inversion. The yield curve is still historically flat, but its recovery shows that the inversion was driven more by buying pressure in long-term yields than an economic panic. There are also no significant signs of stress in other credit markets, leading us to think recent inversion was more a result of short-term technical factors.

“We’ve been encouraged by the recent recovery in long-term yields as global data have improved,” said LPL Research Chief Investment Strategist John Lynch. “Stabilizing growth and healthy domestic inflation could support long-term rates going forward.”

While yield curve inversion is worth monitoring, we would become more concerned if the negative spread were to widen significantly. Historically, the spread between the 3-month and 10-year yields has become much more predictive of a recession at -50 basis points (-0.50%). The U.S. economy has averaged about 13 months to an economic peak when the spread falls that low, and other parts of the curve have inverted at that point.

For more of our thoughts on the economic landscape, check out this week’s Weekly Economic Commentary.

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