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Milan Cacic

October 27, 2023

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THE YIELD CURVE IS TRYING TO TELL US SOMETHING!

As depicted in the graphic below, the yield (interest rate) you receive on a bond usually increases as you purchase longer-term bonds. For example, a normal yield curve might have 3% for a 1-year bond, 4% for a 5-year bond, and 5% for a 7-year bond.

 

Graph

 

 

Occasionally the yield curve becomes inverted, meaning you receive a higher interest rate on shorter-term bonds than you would for longer-term bonds. An example would be getting 5.2% on a 2-year bond while only receiving 4.8% on a 10-year bond(Current situation in the US). It is important to note that every recession over the past 50 years has been preceded by an inverted yield curve.

 

One common and related tool that economists use to predict whether we are going into a recession is the difference between the 10-year US treasury yield and the 2-year US treasury yield. This is depicted in the chart below. When the blue line is above zero, the 10-year bond is paying more than the 2-year bond (indicating a normal yield curve). When the blue line drops below zero into the lower half of the chart, the yield curve is considered inverted.

 

With historical recessions represented by shaded areas on the chart, you can see clearly that each recession has occurred following an inverted yield curve. Sometimes inversion happens more than a year before the subsequent recession, however, once the yield curve starts to steepen upward and to the right, a recession has always followed very closely. With the yield curve steepening significantly over the past three months, this is a historical signal that a recession is right around the corner. But it’s not all bad news, I should also point out that stock markets usually start to trend upwards once a recession has technically begun. I will talk about why this is the case in future notes once we are officially in recession.

 

Graph 2Source: FRED, ST LOUIS FED

 

I've also included a piece from our CIBC Economics team entitled "All Good Things…".

 

As always, if you have any questions, please feel free to give us a call at any time.

 

Have a great weekend.

 

Milan

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