Does the Yield Curve Predict Recessions?

Real (inflation-adjusted) interest rates matter in economics. 

The real interest rate forecasts the pace of consumption growth over time. 

A high 1-year yield suggests strong growth. A high 10-year yield suggests a high 10-year growth rate.

Growth should accelerate if the 10-year yield exceeds the 1-year yield. 

Inverse real yield curves hinder growth. 

This is consistent with the assumption that individuals use present and future income to determine current consumption spending. 

Those who expect more future income will want to consume more today to compensate. If the individual wants to spend more and save less, real interest rates will increase.

Consider a slow-growing yet uneven economy. If the economy is “shocked” by adverse events (oil price surge, stock market crash, etc.), it can cause a recession.

Inverse yield curves indicate slowing growth. 

Assume it’s approaching zero. A shock in this stage can trigger negative growth. 

As demonstrated in the graph, the real yield curve flattened and inverted prior to each recession. 

Was a recession after a yield curve inversion predictable? No.

The yield curve’s flattening is more of an advanced warning sign of trouble.

If we see a flattening real yield curve today, what it says is that real consumption growth will likely remain low. AND any unexpected negative shocks are likely to lead to a recession.