How it works

But to get a clearer idea of how they work we can imagine traffic on an interstate. Think of 2 and 10 year bonds like car and truck lanes on a highway. Normally, when the 2 year rate is lower than the 10 year, traffic is moving along smoothly. Cars in the two year lane are moving faster than trucks in the tenure. But the Fed raises its benchmark rate if they think things are going too fast in the left lane. Imagine the Fed like the sheriff, enforcing the speed limit.

Raising rates puts a damper on the economy, slowing down those in the fast lane. The short term interest rate is more closely tied to the Federal Reserve funds rate, and it's more connected to how the economy is expected to perform in the short run. The long term interest rate is usually higher. Investors are usually paid more to lend for a longer period of time. As the economy grows you need the money lend out to be worth more when you get it back.

But the long term outlook for the economy may not be changing much. Those trucks chugging along may even speed up a little. Well, you know what happens when the truck's in the right lane are going faster than the cars in the left lane. That's the inversion we talked about earlier. And there's a good chance there's traffic ahead. It becomes more expensive to borrow for the short run than in the long run. All of this affects how people lend and the risks they're willing to take that can help drive a recession.

The unconventional traffic pattern may get people to start changing lanes, adding to the complexity and eventual traffic. It's important to note that the recessions don't happen immediately after the inversion, but it does mean the clock is ticking, especially when it comes to the three month ten year curves that Estrella has done so much work on. The big predictive power is for about a year ahead, maybe a year to a year and a half.

Another caveat is that quick little inversions in the yield curve lasting for a day, a week or even up to a month are considered exceptions to the rule. Instead, it's prolonged month-to-month inversions that suggest a recession is actually coming. It's also important to keep in mind that even a brief yield curve inversion can spook the markets. The fact of the matter is that we don't have the kind of markets that we used to have.

We don't have markets where it's a personal touch to it that we have individual investors out there doing things. Sometimes it's just yield curve inversion can get fed into the electronic trading systems and it can just trigger really fast knee jerk reactions. A lot of this is programmed trading, just computerized trading, especially when you have markets to trade on thin volume it doesn't take a whole lot to move them.

And when something that has the predictive power of an inverted yield curve comes along, it can be very influential in a highly sensitive market. So let's say, the yield curve has actually inverted. What happens between that moment and the theoretical recession that the inversion is predicting? Well, a back and forth tends to emerge for market watchers. And the inversion in 2019 offered a good example with one camp essentially saying this time it's different.

It's always kind of a scary thing to say. This time is different, but I'm going to say it too. The yield curve inversion I would not read too much into. There's no likelihood that the inversion of the yield curve that's occurring in this period a is similar to the ones that occurred in the prior period, or b that it will lead to a recession. And another camp heating the curves warnings. I've been getting this pushback that it's essentially the yield curve is inverted because global means and no. So, you know, it's it's not that good an indicator.

I would actually argue it is a very good indicator because we just find it very hard to see how global growth can be this week and the U.S. can be this one island of of essentially prosperity. I think we're up toward 40 percent of recession risk within the next 12 months. And that's a large part in reflecting what the yield curve is telling us. Amongst the curves detractors some wondered if the very act of watching the curve so closely had undermined its worth as an economic indicator.

Historically, we had not been following the yield curve as closely as we follow it now. There's something called the Heisenberg Uncertainty Principle. Something that's being observed is going to act differently then when it's not being observed. Others pointed to negative sovereign interest rates abroad. You have 20 percent more sovereigns yielding negatively than you had just a few months ago. So there's this drive for yield, attributing the inversion to a spike in demand for long term U.S. treasuries as money fled those negative rates in other countries.

Trade adviser Peter Navarro comes out and says it's just it's just a reflection of the fact that everybody wants our debt. Questions also emerged over whether Federal Reserve policy since 2008 played a role. I think the Fed still has a large balance sheet and that could be putting some downward pressure on those longer term rates. So I'll keep watching that carefully for sure. But I don't yet see the signal that suggest it's time to get worried about a downturn or whether the trade war had contributed.

I think what's happening is the trade tensions are catching up with the market. And I think people realize it's slowing global growth. And this uncertainty does raise the risk of recession to its highest level since the 2008 debacle. And I think that's really what's going on here. Amidst this back and forth. Something interesting happened. The yield curve suddenly un-inverted. Does that mean the recession fears were overblown and the naysayers were right?

Not necessarily. Whenever the yield curve un-inverts or re-steepens, people tend to be happier or more optimistic. If an inversion is a negative sign than necessarily an un-inversion would be a positive sign. And that may make intuitive sense. But what you'll see is if you look at a graph of inversions and recessions lagging thereafter, the yield curve typically un-inverts even before a recession begins. You'll have this inversion with short term rates exceeding long term rates, and then it's not uncommon to see that correct itself, even in the span between the initial inversion and the recession.

In other words, this re steepening has proven part of the yield curve's normal predictive behavior. So the inversion is really just the beginning of the recession warning. But the curve can do all sorts of things as the recession it predicts comes about, at least historically. But looking ahead, the economy's immense complexity could easily surprise experts with deviations from this pattern. It is one indicator. It has been a very good indicator. Is it going to be a foolproof indicator? Only time is going to be able to tell that.