With the Federal Reserve finished raising interest rates in this cycle, a yield curve inversion would signal a coming recession, according to Brian Rehling, co-head of global fixed income and global investment strategy at Wells Fargo Investment Institute.
“We do not recommend that investors assume this time will be different,” he wrote in a report released Wednesday. “Yield curve inversion has delivered a powerful message in recent cycles. In our view, it is a message that is unlikely to change through multiple cycles.”
The 3-month to 10-year curve inverted for a week last month and the 2- to 5-year has been inverted for most of the past four months.
“We are at a key inflection point, and we believe that the yield curve merits close monitoring,” he notes.
With the Fed’s recent dovish turn on monetary policy, “We think that the rate hike cycle likely has come to an end.”
Before each of the past six recessions the yield curve has inverted and is touted as “an important forecasting tool,” although “it is not foolproof — as it does not pinpoint exact timing, or how fast conditions may change,” Rehling writes.
But even when the curve inverts, equity markets continue to perform well for a time. Wells considers inversion “meaningful” if it lasts for four consecutive weeks or the inversion is at least 25 basis points.
Of the more reliable yield curves the 10-to-2-year should be flat or slightly positive in the near term, but the risk of inversion is increasing. “Still, it is important to note that this indicator often turns negative well over a year before a U.S. recession strikes — and that it is most reliable when it inverts by at least 25 basis points,” Rehling writes.
The 10-to-1-year, which remains positive, is his selection as the best recession indicator: “when we consider a four-week inversion trigger, we saw inversion between 19 and 93 weeks before each of the last six recessions with an average of 45 weeks, or just over 10 months before a U.S. recession officially started,” he said. “Using a single 25-basis-point inversion as a trigger offered a similar outcome of predictability.”
While the curve doesn’t invert every time the Fed has a tightening cycle, “Fed tightening does appear to be a necessary component of curve inversion,” Rehling said. “It is possible that, even though the Fed has paused federal funds rate increases, they have already raised rates too far.”
While there is no explanation why an inverted yield curve signals a coming recession, he said, “the evidence clearly suggests that it does.”
