Why does the yield curve tend to invert shortly before a recession?

The yield curve tends to invert shortly before a recession primarily because bond traders predict interest rate cuts in response to a recession. An inverted yield curve occurs when short-term interest rates rise above long-term rates, which is typically a signal that investors expect economic slowdown and are anticipating that central banks will lower interest rates in the future to stimulate the economy.

When the economy shows signs of weakening, traders expect that the central bank will intervene by lowering interest rates to encourage borrowing and spending. As a result, they may seek out long-term bonds in anticipation of these cuts, driving up demand and prices for those bonds and consequently lowering their yields. At the same time, short-term rates may remain higher due to current monetary policy, leading to the inversion of the yield curve. This sentiment often serves as a precursor to economic contraction, making it a key indicator that economists observe when forecasting recessions.

In contrast to this correct reasoning, expectations of economic growth, rising stock markets, or an increase in consumer spending would generally lead to a normal yield curve, where long-term yields are higher than short-term yields due to growing confidence in future economic performance. When trading conditions reflect optimism about future growth, the yield curve usually slopes upwards rather than inverting.