The Yield Curve as a Recession Signal: Take It Seriously, but Not Literally
The sudden inversion of the 2-year, 10-year (2s10s) US Treasury yield curve has investors wondering if a recession is imminent. Inversion of the bellwether 2s10s curve preceded all six recessions since 1978. There has been only one instance in that period where a recession failed to follow a sustained inversion of the curve within two years. In our view, the yield curve's reputation as a recession signal is well earned. That said, it’s not infallible. Though we are wary of suggesting that “it’s different this time,” we see reasons to believe the onset of recession will take longer than usual.
An economy on solid footing
First, consider that the economy remains on solid footing. Consumer balance sheets are still strong, nominal incomes are robust and the corporate sector is very healthy in our view. To be sure, there are significant risks to the expansion. Global central banks are on course to tighten monetary policy amid excessive inflationary pressures. The ongoing war between Russia and Ukraine has added further hardship, supply-side disruptions and geopolitical uncertainty. Still, in the absence of a significant escalation in the Russia-Ukraine conflict, we believe the underlying strength and resiliency of the US and global economies can fuel a sustained expansion. As a result, we believe the probability of recession in the next 12 to 24 months remains relatively low, only modestly above our long-term average probability of 10%-20%.