Yield Curve predicting Recession in 2023

The Yield Curve is heavily inverted right now. A significant warning for the US Economy and Housing Market in 2023.

Historically the Yield Curve has been a strong predictor of both economic expansions and recessions. When the Yield Curve is positive/upward-slopping you can expect a growing economy, housing market, and stock market in the future. But when the Yield Curve goes negative (aka inverted), it suggests that a recession is coming.

The scary thing for the US Economy right now is that the Yield Curve is the most inverted it's been in over 40 Years, with the difference between the 10-Year US Treasury (3.58%) and 1-Year US Treasury (4.76%) an astounding -1.18%.

The Yield Curve can be confusing to some. What is it exactly? Why is it important? I will answer those questions as this post goes along. But for now, focus on understanding one thing: the Yield Curve is a remarkably accurate forecaster of the economy. In fact, every time the 10/1-Yr Yield Curve has inverted in the last 50 years, a Recession has followed within two years.

On average - the Recession starts 14 Months after the Yield Curve inverts. And if this historical average holds, it would place the next Recession start date in September 2023 (14 Months after the initial inversion in July 2022).

Of course - 14 Months is just an average. Sometimes the duration from Inversion to Recession is shorter, like in the COVID Recession, which occurred only 6 Months after the August 2019 Inversion. In other cases, it takes longer, like during the Great Recession, whose December 2007 start date was 23 Months after Initial Inversion.

Predicting the Stock / Housing Crash

But what's amazing about the Yield Curve is not just its ability to predict a Recession. It also predicts events tangential to a Recession. Like a crash in the Stock Market & Housing Market.

Let's start by talking about the Housing Market. In the last National Housing Crash, which occurred from 2007 to 2012, the inversion that started in January 2006 was a signal that Home Prices would decline for the next 6 Years. Prices didn't bottom until February 2012.

A similar situation played out in the early late 1980s/early 90s. An initial Yield Curve Inversion in February 1989 predicted half-decade Housing Crashes in cities like Los Angeles, Boston, and New York. The Housing Crash in Los Angeles was particularly brutal, with prices declining by 26% over six years.

The Yield Curve Inversion is historically an early indicator of an Asset Crash. Not just in Housing, but also in Stocks. Over the previous eight recessions, the Yield Curve inverted 23 Months before the S&P 500 hit a bottom.

This suggests that July 2022's Inversion is forecasting a bottom in stocks by June 2024. Another year and a half from today.

We're Not Even Close to a Bottom

This Yield Curve data is sobering. It smacks you across the face and makes you realize we're not even close to a bottom in Housing and Stocks. And that the Recession, which is underway in certain industries, is going to get worse before it gets better.

This means that a homebuyer or investor who's planning to buy in 2023 should expect the value of their house to continue declining after they purchase it. And potentially for the value to decline for a long time.

Housing Crashes and Recessions are slow-moving beasts, and we're in the early stages of both given the recent Yield Curve Inversion. There will be a temptation to think the worst is over in 6 or 12 Months. Chances are it will be just the start.

To be clear - this doesn't mean don't buy real estate in 2023. Rather, it means having realistic expectations about what you're getting into. If you do buy, make sure it's a property you're ready to hold for 10 Years. Try to keep your monthly payment for mortgage interest, taxes, and insurance at less than 25% of your income. If you're an investor, make sure the property cash flows from Day 1 at a decent cap rate (over 7%, ideally).

What is the Yield Curve, Anyway?

But hold on a second...what is this Yield Curve thing, anyway? Why does it have this mythical power to predict Recessions and Asset Crashes? Is there any way it could be wrong this time? Let's answer these questions one by one.

What is it? The Yield Curve is a function of the bond market. Specifically the US Treasury market. In normal times, longer-term US Treasuries, such as the 10-Year or 30-Year, offer a yield (aka interest rate) than short-term Treasuries. This is to compensate the buyers for the increased risk of inflation in the long run. And in general, this positive-sloping yield curve is a signal of economic expansion into the future.

Its Mythical Power. But when the Yield Curve inverts, it means that longer-term Treasuries are offering a lower yield than short-term treasuries (orange line in the graph below). Which doesn't make intuitive sense. Why does someone get compensated more for buying a 1-Year Treasury right now than a 10-Year Treasury?

To understand why the Yield Curve inverts, and why it predicts recessions, you need to understand who controls Treasury Yields. In the case of Short-Term Yields (1-Year/2-Year), it's the Federal Reserve. The more Jerome Powell and the Fed hike Interest Rates, the more Short-Term Yields will increase.

But the Fed does not have as much control over Long-Term Yields (10-Year/30-Year). Rather - these are controlled mostly by commercial banks, pension funds, and other governments. If these entities want to buy more Long-Term Treasuries, that will cause yields to go down (higher demand = interest rates don't need to be as high to entice buyers).

So an Inverted Yield Curve occurs when there's a combination of Fed Rate Hikes and increased institutional demand for Long-Term Treasuries. Both of these are behaviors that indicate a Recession is near. Fed Rate Hikes increase the cost of borrowing for consumers and businesses, suppressing demand in the economy. Meanwhile, when large entities buy Long-Term Treasuries, it's a sign that they're becoming risk averse. Rather than funding private sector loans that expand the economy, they're buying Long-Term Government Treasuries because they're a "safe asset". This reduces investment in the economy.

If reduced demand and investment last long enough, you get a recession. And a potential Stock & Housing Crash if asset values are high enough.

But could the Yield Curve be wrong this time? Anything is possible. The 1/10-year Curve inverted back in the mid-1960s and there was no immediate recession. So there have been some false signals if you look back far enough into history.

However, I don't think this is a false signal in 2022. The level of inversion is simply too great. The 10-Year Yield offering 33% less relative return than the 1-Year is historically unprecedented. It's signaling that the Fed has already hiked interest rates too far. And that a economic downturn is coming, potentially by the middle of 2023.