There have been 7 major U.S. recessions since 1960, and all were preceded by a common pattern in the U.S. economy—the inverted yield curve.
A yield curve represents the different interest rates that are paid to people who own bonds by each of the U.S. Treasuries. Namely the US 3 month, 2 year, 5 year, 10 year and 30 year.
A bond, in general, is an agreement stating that if you loan an entity money (such as a government or a corporation) they will pay back the original coupon plus interest.
If the government holds on to your money for a longer amount of time then you should be paid more.
For example; owners of the 30 year US treasury are paid more than owners of a 3-month treasury. This is because the more time money sits in a bond, the higher the risk of the investment failing and therefore one should be compensated for the increased risk.
The chart below depicts a normal, upward sloping yield curve among the five aforementioned US Treasury securities. The graph depicts actual yields in the Treasury market at the end of 2021.
An inverted yield curve means instead of the rate (or yield) increasing as you move the bonds maturity date further out, the yield actually decreases. The resulting graph is a mirror image of the archetypal yield curve – with yield decreasing as the bonds maturity date moves further out. Economists interpret this as a warning sign for a recession in the economy.
This is because the inversion suggests that while investors expect interest rates to rise in the near term, they believe that higher borrowing costs will eventually hurt the economy, forcing the Fed to later ease monetary policy.
More intuitively: as concerns of an impending recession increase, investors tend to buy longer term Treasury bonds. This is based on the premise that these longer term bonds offer a safe harbour from falling equities markets, provide preservation of capital, and have the potential for appreciation in value as interest rates decline in future as a result of easing monetary policy.
As a result of the rotation to longer maturities, yields can fall below short-term rates, forming an inverted yield curve. This is because price and yields for bonds have an inverse relationship.