On Friday, the bond market once again flashed what has historically been a reliable sign of an impending U.S. recession — an inverted U.S. Treasury bond yield curve — after trade tensions with China heated up, triggering a 2.6% sell-off in the broader stock market. This indicator has occurred several times since Wednesday, Aug. 14, when it spooked the market and resulted in the S&P 500 index falling nearly 3%.
The inverted yield curve first sounded the economic-downturn-ahead alarm in March, but last week marked the first time since late 2005 that there was an inversion on what’s considered the main part of the yield curve.
If this leading inverse economic indicator still has its good predictive mojo, the stock market’s roaring, decade-long bull market could be coming to an end. Here’s what you should know.
What’s an inverted yield curve?
An inverted yield curve occurs when interest rates on bonds with longer maturities are lower than those on bonds with shorter maturities. It occurs because investors are anxious about the economic climate and are pouring money into longer-term bonds, which they see as safe havens. As money flows in, the prices on these bonds go up — in a typical supply/demand fashion — while yields go down.
It’s worth noting two things: Some economists believe that the inverted yield curve doesn’t have the same predictive power that it once possessed, and there can be a considerable time between this phenomenon and the start of a recession. The length of time between an inverted yield curve and the official start of a recession has ranged from several months to about two years.