Yield curve inversions, un-inversions, and US recessions

The figure below (source: Federal Reserve Bank of St. Louis) displays the spread between the 10-year and 3-month U.S. Treasury yields from the early 1980s through 2025. This yield spread is a closely watched indicator in financial markets, as it reflects investor expectations about future economic conditions. A yield curve inversion—occurring when the spread falls below zero, meaning short-term interest rates exceed long-term rates—has historically been associated with upcoming recessions. Economists and policymakers often regard this inversion as a reliable leading indicator, given its strong track record in signaling economic downturns with a lead time of several months to over a year. As shown in the graph, each sustained inversion over the past four decades has typically preceded a recession, underscoring its continued relevance in macroeconomic forecasting.

It is important to note that the yield curve typically un-inverts, or returns to a positive slope, before a recession actually begins. In the graph, recessions are represented by the shaded areas, and a close examination reveals that the un-inversion often precedes the onset of these downturns. However, the time gap between the un-inversion and the start of a recession can vary significantly, ranging from a few months to over a year. This variability highlights the complexity of using the yield curve as a precise timing tool, even though it remains a valuable early warning signal. For a brief discussion on this pattern, along with a few other related topics, please refer to the video linked below.

Do equity indices bottom before recessions?

An interesting debate taking place right now (November 2022) relates to whether the equities market has already priced in a recession, and is now moving up into what could be a new bull market. This could mean that the forward-looking equities market, represented by equity indices (e.g., Wilshire 5000, S&P 500), has bottomed before a recession.

I have conducted a rather extensive review of various equity indices to see if there is a historical precedent, prior to November 2022, for an index that has bottomed before a recession. I could not find any. The figure below (source: Federal Reserve Bank of St. Louis) shows the Wilshire 5000, which covers all American stocks.

The figure shows two areas where the index bottomed after a recession and during a recession. These are only illustrations of a broader pattern - I could find no instance in which a bottom occurred before a recession, in any index (including the S&P 500). So, do equity indices bottom before recessions? Apparently not. The video linked below discusses this and other cases in more detail.

The crash of 1987 happened as the yield curve was steepening

Summary

- It is generally considered a bad sign if the 10y-3mo or the 10y-2y differences in yields fall.

- This is particularly true if the differences in yields fall below zero (a yield curve inversion).

- However, the crash of 1987 happened as the yield curve was steepening, not flattening or inverting.

A crash without an inversion

When talk of a market crash intensifies, many people look for clues from the US Federal debt market to assess the probability of a crash happening soon. There is a widespread belief that the main clues come from Treasury yield differences, or the yields paid by US Federal debt instruments with different maturities.

It is a bad sign if the 10y-3mo or the 10y-2y differences in yields fall below zero (a yield curve inversion). However, as you can see on the figure below, the 1987 stock market crash happened around the time the 10y-3mo and 10y-2y yields peaked.

We show both the 10y-3mo and the 10y-2y differences in yields because some market experts have more confidence in the 10y-3mo signals, whereas others prefer those given by the 10y-2y differences. The reality seems to be that both the 10y-3mo and the 10y-2y differences in yields provide the same overall signals.

But the inversion preceded the recession

Having said that, the 1987 crash was followed by another smaller crash, related to the 1990 recession. This recession was indeed preceded by a yield curve inversion.

So, one could say that the yield curve inversion worked yet again, as it has done repeatedly, as a leading indicator of a recession.

Conclusion

The yield curve inversion phenomenon is a very good predictor of economic recessions, arguably one of the best leading indicators available to investors. And market crashes usually happen around recessions. But a market crash may happen without an economic recession.

In fact, the crash of 1987 happened as the yield curve was steepening, which is essentially the opposite of flattening – and arguably a bullish signal.

Does yield curve flattening hurt US bank stocks?

Summary

- US banks derive part of their income from borrowing funds and investing them, with interest rates paid and earned being correlated with the short and long ends of the Treasuries yield curve.

- Since the short end yields (for Treasuries) tend to be lower than the long end yields, usually US banks benefit financially from the difference.

- Given this, one would expect bank stocks to be strongly and positively correlated with yield curve steepening; i.e., the opposite of flattening.

- If we look at data from the past 5 years, however, the opposite has happened. As the yield curve has flattened, bank stocks have gone up.

Yield curve flattening and US bank stocks

US banks derive part of their income from borrowing funds and investing them, with interest rates paid and earned by the banks being correlated with the short and long end of the yield curve. Since the short end yields (for Treasuries) tend to be lower than the long end yields, usually US banks benefit from the difference. Given this, one would expect bank stocks to be strongly and positively correlated with yield curve steepening; i.e., the opposite of flattening.

The figure below shows, at the top, the difference in yields for 10-year and 3-month Treasuries for the past 5 years. The two graphs at the bottom show the stock prices for two banks: JPMorgan Chase, representing multinational investment banks; and U.S. Bancorp, representing regional banks. The sources for the graphs are Yahoo Finance and the US Federal Reserve Economic Data (FRED) (, ).

As you can see, prior to COVID there seems indeed to be a correlation between US bank stocks and yield curve flattening. However, it is the opposite of what we would expect. The correlation is negative. As the curve flattens, bank stocks go up. In other words, US banks tend to do well in response to what could be seen as a major obstacle to profitability.

What is happening? Compensatory adaptation

As the yield curve flattens, US banks react in a compensatory way – e.g., by resorting to other sources of income. This is compensatory adaption theory at work (, ).

Compensatory adaptation of this type is facilitated by the size and flexibility of the US economy. This makes the environment in which US banks operate significantly different from those of Japan and Europe, where arguably banks have fared worse.