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Spot the recession: the key warning sign of economic slowdown Add to ...

Federal Reserve tapering, government shutdowns and the like: there is always something to worry about. But the fears are usually overblown. What matters more is “inversion of the yield curve.” When it shows up, then we can really start worrying about recessions and bear markets in stocks and housing.

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Inversion of the yield curve occurs when short-term yields on fixed-income securities rise above long-term yields. Most of the time, short-term rates are lower. Right now in Canada, for example, government bonds stand at 0.98 per cent on three-month treasury bills, 2.5 per cent on 10-year maturities and 3.07 per cent on 30-year maturities (in between are many other maturities).

But short-term yields can climb above long-term yields when central banks push them up. They do this by dumping some of their holdings of treasury bills, causing prices to fall and yields to rise (prices and yields for bills and bonds are inversely related). Such selling is undertaken to cool off an overheated economy.

All U.S. recessions from the 1950s onwards were preceded by an inverted yield curve six to 18 months before. A number of studies have documented the relationship, a recent case being the paper written by Tobias Adrian and Arturo Estrella at the Federal Reserve Bank of New York.

Why does an inverted yield curve bring down an economy? One big reason is that banks earn profits by borrowing at short-term rates and lending at long-term rates, so they encounter negative profit margins whenever inversion occurs. This leads to banks winding down their lending, cutting off an important source of credit for businesses and consumers.

As long as money and credit is flowing, economies, stocks and housing tend to be resilient, albeit with episodes of volatility just to keep things interesting. Staying the course is likely to work well for businesses, investors and families as long as the yield curve in the U.S. or one’s country is not inverted.

When might inversion occur? My guess is that the global economy is at least two to three years away. As indicated by currently low rates of employment and capacity utilization, economic slack still abounds. Moreover, policymakers are not going to ramp up their economies too aggressively for fear bond markets will revolt – as discussed in "Can government debt be inflated away? Not likely." In short, it will take some time to reach the stage where economies become overheated enough to generate the inflationary pressures that cause policymakers to jack-up short-term rates.

Larry MacDonald is a retired economist who manages his own portfolio and writes on investing topics. He tweets at @Larry_MacDonald

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