A widely watched recession signal has been flashing red for months. However, the performance of one key indicator suggests it might not be as alarming a warning as U.S. economists might anticipate.

A yield curve inversion has become a widely recognized economic warning sign, though its reliability as an indication of recession in the United States remains uncertain. Traders and investors are closely watching to see if there will be another inversion between two-year and 10-year Treasury yields.

The Inverted Yield Curve

Morningstar reports that the bond market's most deeply inverted gauge is signaling an impending "large slowdown" in economic growth. As global economic risks rise, investors are paying attention to the spread between two-year and 10-year Treasury bonds for clues as to where interest rates may head.

A yield curve inversion occurs when long-term yields decline faster than short-term ones, typically during an economic downturn.

An inverted yield curve occurs when demand for longer-term securities like treasuries and mortgages increases while supply of shorter-term bonds decreases. This pushes up both their prices as well as their corresponding yields.

An inverted yield curve is generally unfavorable, but it doesn't always portend a recession. According to Anu Gaggar - global investment strategist at Commonwealth Financial Network - 22 of 28 inversions since 1900 have been followed by recession; however, the average time between inversion and recession was approximately 22 months.

Recessions often begin with a steeper yield curve due to factors like rising inflation and the Fed's decision to raise interest rates.

In times of economic downturn, people often look towards the long end of the yield curve for greater potential returns. While longer-term securities offer higher yields, they may also be subject to reinvestment risk when prices are declining.

In such scenarios, a yield curve inversion can be beneficial as it helps prevent the economy from overheating. A steeper curve also helps keep inflation low and businesses avoid costly liquidity crunches.

For instance, a yield curve inversion can assist banks and companies with their cash flow during an economic downturn by making them more competitive. They could offer lower interest rates to attract new clients and make up for lost margins during a downturn, helping them remain profitable even in weak economies.

Though an inverted yield curve can serve as a strong warning that recession is imminent, only six times since 1978 has an inversion been preceded by such events - and those were due to global pandemics.

Inverted Yield Curves are a Recession Harbinger

History suggests that when the yield curve inverts, it usually signals that a recession is about to commence. However, this is not always the case.

Sometimes, it takes several years before an economy is truly at risk of entering recession. This is because recessions take time to develop and can be caused by a variety of factors.

When an economy is about to enter a recession, investors often become anxious about their investment choices and become less risk-averse. This leads to lower prices for long-term Treasury bonds and an inverted curve.

A yield curve is a graph that displays the interest rate on Treasury bonds with various maturities. It typically plots shorter-term securities such as 2-year Treasury notes against longer-term obligations like 10-year Treasury bonds.

The graph can display either a flat or steep curve depending on whether short-term yields are higher than long-term ones. A steeper curve usually signals expectations for stronger economic activity, inflation and interest rates in the near term.

This graph also illustrates that the curve typically peaks before recessions and then declines after they start, so it cannot be used to accurately forecast a future downturn.

Despite these caveats, the curve can still be beneficial to investors. It helps them make informed investment decisions and safeguard their wealth during recessionary periods.

If you want to use this curve as an indication of an impending recession, you need to understand its meaning and how to recognize it. Experts typically look at two indicators: the spread between three-month Treasury bills and 10-year Treasuries, as well as the two-to-10 (210) segment of the curve.

Inverse yield curves are a major concern as they often indicate that the Federal Reserve will be raising interest rates rapidly. This could have an adverse effect on the economy by decreasing spending and business activity.

Investors with money in equities should watch out for signs of an inverted curve. Stock markets tend to decline when this occurs, as investors fear a recession will lead to lower profits and share prices for companies.

Inverted Yield Curves Are a Warning

When the yield curve between 2-year and 10-year Treasury notes inverts, it's an indication that markets expect slow growth. Furthermore, it could signal that the Federal Reserve may soon feel compelled to cut short-term rates in order to stimulate the economy.

Inverted curves have historically been a reliable indicator of recessions, particularly when they appear six to 18 months before one begins. Unfortunately, they cannot guarantee when or how deep a downturn will start.

Wednesday's stock market plunge was caused by bond investors' concerns that economic growth will slow. That the two-year yield is higher than the 10-year rate for the first time in 12 years and that there is now a negative difference between long-term and short-term rates - something not seen since 2007.

Bank of America Merrill Lynch economists stated in a report on Monday that the bond-market's most deeply inverted gauge indicates an "important slowdown" in the US economy. They further predicted that the Fed may soon start raising interest rates to combat this slow growth, which they warned is "very negative for stock prices."

Central banks have always been wary of rising inflation, and the consensus view is that rates must stay high to combat a four-decade high. That's why the Federal Reserve raised its short-term rate in September and said it plans to do so at each meeting until yearend.

But there are a few other considerations to be aware of. A recession typically occurs when short-term interest rates are higher than long-term ones and inflation is declining.

History suggests recessions typically begin when the spread between two-year and 10-year Treasury yields inverts, as it has done recently. Since World War II, every time this rate has fallen below the two-year rate, a recession followed.

Inverted Yield Curves Are a Recession Warning

When short-term rates are higher than long-term ones, the yield curve is said to invert. This could be a signal that the economy could be entering recession; however, it should be remembered that this indicator is not always reliable and an inverted yield curve does not always indicate one.

Market participants and financial media are alarmed by the recent inversion, which has been known to accurately forecast every recession since 1956 and is at its most extreme since 1981-82.

The curve inversion has been caused by a combination of strong economic data, high inflation and the Fed's ongoing bond-buying program. Therefore, it remains uncertain when or if this trend will reverse itself.

In addition to the economy, the trade dispute between the United States and China is another important factor driving this inversion. If this issue does not be resolved, it could trigger another recession.

A recession occurs when the economy slows down and begins to lose momentum. This can lead to various issues within the economy, such as an increase in unemployment rates, decreased spending, decreased exports, and diminished consumer confidence.

Once the trade dispute is settled, it's likely that the yield curve won't invert again. This is because investors will begin to value newer bonds more highly and seek them out instead of older ones.

One aspect to take into account is the Fed's massive bond-buying program has lowered the yield on 10-year Treasury securities, so if they hadn't done this, the curve would likely be closer to flat and less inverted.

Furthermore, a recession could occur if the Federal Reserve stops raising interest rates too soon, potentially leading to an acceleration in inflation. As such, businesses might find it harder to borrow money to expand their operations.

Recessions typically happen about every five years, and the inverted curve isn't a reliable predictor when they will occur. Nonetheless, investors can use it as an aid as long as they understand its limitations.