Is the yield curve telling us that a recession is around the corner?

Inverted yield curves have historically been predictors of recessions, or, rather, of the last phase of an economic expansion. So, is the yield curve telling us that a recession is around the corner?

If we think of market yields as expectations of future Fed funds rates, the current yield curve is saying that the market is expecting the Fed to continue its tighten cycle for some time to come, but that the Fed will be forced to cut rates again well before yield levels have reached historically normal levels.

Usually this type of analysis is complicated by the fact that yields reflect not just expectation, but also compensation for taking risk. However, at the moment the EDHEC Bond Risk Premium Monitor is showing very small and very similar risk compensations for the 2 - and 5-year yields. This means that the current inversion is best explained in terms of expectations of future rate cuts; and the best explanation for this is that a recession may be not too far off.

How far is “not too far off”? Interestingly, as early as September, the median of the “blue dots” released by the Fed (dots that represent the most likely values for the future Fed funds rates expected by the members of the Fed Monetary committee), already clearly showed a dip between 2 and 5 years. Already in September, the US monetary authorities were contemplating the possibility that rates would have to be cut as early as in three years’ time. So, if anything, the market appears to have been a bit complacent or “behind the curve”. 

It was extremely interesting to watch the December release of the “blue dots”, and the market reactions.