Markets don’t predict recessions - but bond markets come close

By José Villalta

Human beings have always wanted to catch a glimpse of the future, and economics is no exception. Countless models and theories have been built to forecast what comes next. Over the past 50 years, one indicator has preceded nearly every U.S. recession: the yield curve.

What the yield curve is

The yield curve is a graphical representation of interest rates on debt instruments across different maturities. It reflects expectations of future short-term rates and the term premium. The most widely followed measure is the spread between the 10-year and 2-year Treasury yields, though the 10-year and 3-month spread is often considered more robust from an academic perspective.

When the curve slopes upward, it reflects expectations of growth and inflation; when it is flat, it signals a transition phase; and when it is inverted, it reflects restrictive monetary conditions and/or expectations of a slowdown. An inverted yield curve occurs when long-term rates fall below short-term rates.

A track record built over decades

The concept dates back to the early 20th century, when governments began issuing debt across different maturities. It gained prominence in the 1960s, when economists started linking its shape to economic cycles, and by the mid-1970s a strong empirical relationship had been established between the curve’s shape and recessions.

This century, an inversion appeared in 2006, followed by the 2007–2008 recession. Likewise, the disruption of 2020 was preceded by an inverted curve in 2019.

The inversion of the yield curve has a strong historical record of preceding periods of economic stress. This cycle may behave differently, but markets rarely abandon patterns without reason — which is why central banks and portfolio managers still watch this indicator closely.