The inversion of the yield on the 10-year Treasury note to the federal funds rate is considered a reliable recession indicator due to the following reasons:

1. Economic Expectations and Market Sentiment

- Long-term vs. Short-term Yields: Normally, long-term interest rates (like the 10-year Treasury yield) are higher than short-term rates (like the federal funds rate) to compensate investors for the risks associated with time. When long-term yields fall below short-term yields, it indicates that investors expect lower growth and possibly lower inflation in the future.

- Flight to Safety: Investors buy long-term Treasury bonds as a safe investment when they are worried about the economy. This increased demand for long-term bonds drives their prices up and yields down.

2. Interest Rate Impact on Economy

- Monetary Policy: The Federal Reserve controls the federal funds rate, which influences short-term interest rates. An inverted yield curve can occur if the Fed has raised short-term rates to cool down an overheating economy or control inflation.

- Credit Conditions: An inverted yield curve signals tighter credit conditions. Higher short-term rates make borrowing more expensive, which can slow down economic activity as businesses and consumers reduce spending and investment.

3. Historical Precedent

- Past Recessions: Historically, every recession in the past several decades has been preceded by an inverted yield curve. This pattern has made the inversion a closely watched indicator by economists, investors, and policymakers.

4. Behavioral Aspects

- Expectations of Future Monetary Policy: An inverted yield curve often reflects expectations that the Fed will have to cut interest rates in the future to support the economy, which typically happens in response to economic slowdowns.

- Predictive Power: While not perfect, the yield curve inversion has shown a strong track record of predicting economic downturns. The consistent pattern has made it a valuable tool for forecasting.

Detailed Mechanism of Inversion as a Recession Indicator

1. Expectations of Lower Future Growth: When long-term yields fall below short-term yields, it indicates that investors expect slower economic growth and possibly a future easing of monetary policy.

2. Impact on Lending and Spending: Higher short-term interest rates discourage borrowing and spending by businesses and consumers, which can lead to a slowdown in economic activity.

3. Investor Behavior: Investors moving funds into long-term Treasuries for safety drive up their prices and push down yields, reinforcing the inversion.

Summary

The inversion of the 10-year Treasury note yield relative to the federal funds rate is a reliable recession indicator because it reflects collective market expectations of future economic conditions, tighter credit conditions, and a historical precedent of preceding recessions. This inversion signals that investors foresee an economic downturn, prompting them to seek safer, long-term investments, which in turn affects interest rates and economic activity.

If the prediction plays out you will continue to see mortgage rates decrease into the new year. However, trying to time the movement is a fools game. My suggestion is that if you’re in the market to take advantage of these lower rates either through purchase a home or by refinancing, I would strongly suggest working with a mortgage professional who will guide and consult you, not sell you!

Todd Hanley, RICP®, CMA™