Ecoinometrics - Lead time to a recession

The inversion of the yield curve is a harbinger of recession. But how far away are we from it?

If you read the macroeconomic tea leaves you’ll undoubtedly find signs pointing towards a recession for 2023.

The most prominent of those signs is the inversion of the yield curve.

But what is the typical time between an inversion event and the start of an actual recession?

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Lead time to a recession

If you aren’t familiar with it, this is what we are talking about when we say that the yield curve is inverted.

This chart shows the yield for different durations of US Treasury bonds.

In normal times the longer the duration the higher the yield. This is just a simpler fact that investors buying those long duration bonds want to be compensated for the long term risk of holding these assets. The longer you hold, the more uncertainty there is, the more you demand to be paid for it.

That’s why in a normal situation the yield curve looks more like that.

But when investors expect a recession they anticipate rates to fall in the future. That means the yield for long duration bonds has to move lower to reflect this belief. And this is what triggers the inversion.

Now an inverted yield curve doesn’t exactly trigger a recession. But it typically doesn’t help with the credit conditions. 

Most of the time banks borrow short term and lend long term. So when the yield curve is inverted they are borrowing at higher rates and lending at lower rates. This is not what they want. And as a result credit conditions get tighter.

You can argue that in a system fuelled by debt this could alone trigger an economic downturn. But if we are talking about a severe recession this is usually not enough.

Regardless looking at the past 80 years every time we had an inversion of the yield curve (here negative 10-year to 1-year spread) a recession followed.