The 'yield curve' can show rising risks of an economic 'shock,' St. Louis Fed says

  • Inversions have preceded economic recessions in the U.S. since at least the 1960s.
  • A higher rate on the 10-year Treasury compared to the 1-year Treasury is an indicator that growth will accelerate. But when that flips, economic growth is expected to slow.
  • Recession is more likely when the adverse events hit an economy at a point when it is low-growth as opposed to high-growth, the St. Louis Fed said.
A woman shops at Walmart near the Green Acres Mall on November 24, 2017 in Valley Stream, NY. 
Stephanie Keith | Getty Images
A woman shops at Walmart near the Green Acres Mall on November 24, 2017 in Valley Stream, NY. 

Yes, this is another story about the dreaded yield curve.

Late last week, the St. Louis Fed weighed in on the topic, examining why economic recessions tend to follow periods when short-term interest rates spike higher than longer-term rates along a continuum of interest rates called the yield curve.

This phenomenon is what bond experts call an inversion. And lately, it's been getting dangerously close to being reality.

The St. Louis Fed concluded that the present growth rate of about 1 percent year over year is lower than the historical average of 2 percent, raising the risk that a negative shock could put the economy into recession.

Inversions have preceded economic recessions in the U.S. since at least the 1960s. But the St. Louis Fed wondered in a research note whether an inversion forecast recession or whether it forecast the economic conditions that make recession more likely.

As the St. Louis Fed pointed out, real interest rates reflect expectations for consumption, which drives the U.S. economy. A higher rate on the 10-year Treasury compared to the 1-year Treasury is an indicator that growth will accelerate. But when that flips, economic growth is expected to slow.

Source: Federal Reserve Bank of St. Louis

But even strong economies experience adverse events, like a market downturn or an oil price shock. And economies sometimes grow unevenly. Recession is more likely when the adverse events hit an economy at a point when it is low-growth as opposed to high-growth, the St. Louis Fed said.

It pointed to three periods in the recent past when the difference between short and long-term rates narrowed or flipped, and then looked at what happened next. After 1988-89, the economy dipped into recession in 1990, but more likely because Iraq's invasion of Kuwait caused oil prices to spike. The recessions of 2001 and 2007-09 were caused by the collapse of asset prices.

"It seems unlikely that the timing of these events could be forecasted with precision," the St. Louis Fed said.

When consumption is slowing, economies are more vulnerable to "negative" shocks that turn into recessions. "While the exact date at which the shock arrives is itself unpredictable, the likelihood of recession is higher relative to a high-real-interest-rate, high-growth economy."