Given the inverted yield curve and its correlation to predicting recessions, the risk of recession is still elevated, explains Collin. The yield curve is inverted when long-term treasury yields fall below short-term treasury yields.

For example, the 10-year treasury yield is about 3-1/2% %, but the two-year treasury yield is about 4%. And the yield curve tends to invert once the markets begin pricing in Fed rate cuts and tends to send long-term yields lower. Long-term yields like that 10-year treasury yield are often based on Fed Funds Rate expectations over the next 10 years or so. So if the Fed Funds Rate is 5% like it is today, but the Fed Funds Rate is expected to be lower in a year or two, you’ll tend to see longer term yields decline to sort of average out what the Fed Funds Rate might be over the next number of years.

An inverted yield curve is usually followed by a recession. When the Fed hikes rates, it often slows growth along with inflation. It doesn’t necessarily just bring inflation down. When the Fed hikes rates, things in the economy and financial markets tend to break. Maybe the economy slows, maybe corporate defaults pick up, but any way you slice it, there can be negative consequences from Fed rate hikes. So when things break, the Fed then tends to cut rates to stimulate the economy, which can un-invert the yield curve. For example, short-term Treasury bills or treasury notes could fall if and when the Fed cuts rates and they tend to fall below that level of long-term yields.

Now, we think that’s what’s led to the yield curve being less inverted now, it’s really just due to expectations of sooner than expected rate cuts, so short-term rates have fallen more than long-term yields have declined. But if an inverted yield curve is usually followed by a recession, that doesn’t mean that the fact that the yield curve is becoming less inverted is sending a positive signal about the economy.

Just the presence of rate cut expectations tells us that the likelihood of a recession is on the rise, mainly because the Fed cuts rates when they need to, when they need to stimulate the economy. And we think, unfortunately, the Fed will tighten enough right now, not just to slow inflation, but they’ll likely weaken the labor market, which can lead to slower consumer spending, and then the risk of recession is still there.

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