Originally posted on March 29, 2019 on Forbes.com by Leon LaBrecque, Forbes Contributor.  View the orginal post here

There’s a lot of chatter about the inversion of the yield curve and how it’s an indicator of an impending recession. To better understand, let's take a look at both the history, and the current situation.

Remember that a recession is generally defined as two consecutive quarters of negative GDP growth. It’s a period of economic decline with a reduction in trade and industry activity, and a natural part of the business cycle. There are multiple other characteristics associated with recessions, but for our purposes, the general definition is adequate.

What’s the yield curve? Simply stated, the yield curve is a graph that plots the interest rate yield on bonds (of equal quality) over varying maturities. Most of the time, the shorter maturities have a lower yield than the longer maturities. This makes sense since investors usually want a higher return in exchange for tying up their money for a more extended period.

Typically, investors will want about 1% (100 basis points) more from a 10-year Treasury than a 2-year Treasury. This is logical: the longer you put your money out, the more you want in return. Factor in that there’s more risk in the longer term: risk of inflation or of default (unlikely in a Treasury security).

Yield curves come in many shapes. A standard yield curve is upward sloping (see 2011 below). A flat yield curve is when long term and short-term rates are about equal (see 2007 below). An inverted yield curve is an indicator of trouble on the horizon when short-term rates are higher than long term rates (see October 2000 below).

What’s an Inversion? An inversion is when the short-term rates are higher than the long-term rates. There are many types of inversions, but the standard is the 10-year Treasury yield minus the 2-year Treasury yield. When an inversion happens, the 2-year Treasury has a higher yield than the 10-year.  According to James Bullard, Chief of St Louis Fed, the inversion tends to be a harbinger of prospects for lower long-term growth and lower inflation. An inversion can mean that investors see more risk in the short run than the long run. It also is an indicator of a disconnect in the outlook between the Fed and the market.

Is an inversion a predictor of a recession? In general, an inversion is a good predictor of lower growth and a subsequent recession. Consider the following chart from the Fed:

Since 1978, we’ve seen the following inversions and subsequent recessions:

Does an inverted yield curve cause a recession? In a recent Fed blog, David Wheellock shared the Fed’s survey of commercial lenders and how lenders tend to tighten credit standards after an inversion. He shares the following chart:

The chart shows that credit tightening tends to run commensurate with the inversion. The blog also mentioned that lenders indicated their reasons for tightening credit in an inversion included:

Loans become less profitable when short-term rates are higher

Banks’ risk standards get more stringent

An inversion may signal a less-positive economic outlook

Cause and Effect.  Does an inversion cause a recession, or does an inversion cause banks to tighten lending, which then creates a recession? Is an inversion the indication of a weak economy, or is the inversion a self-fulfilling prophecy? If so, does a tightening by the Fed cause the inversion and thus cause the recession? These questions are valid, and their answers are worth investigating. It should be noted that if we look at Fed funds rates after near-inversions or inversions, the Fed lags in lowering rates.  There are two conspicuous exceptions to this, but in 11/13 cases, the Fed lagged in cutting rates too long, and the outcome had been cast. Perhaps further evidence of the Fed’s lag is their comment about a possible reduction in bonds in the Fed Balance Sheet in September. Whether the inversion precedes the tightening or vice versa, what we know is that the yield curve inversion preceded each of the last 11 recessions, and that alone is strong evidence of correlation.  Recessions can be and are opportunities. The point is not to inspire panic, but to equip ourselves with knowledge of previous patterns so that we can focus our efforts on planning and preparation.

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View Leon LaBrecque's Forbes contributor profile and other blog posts here: https://www.forbes.com/sites/leonlabrecque/

Image: Getty, Forbes.com original post.