Inverted yield curve

The yield curve is a graph showing government bond rates across different maturities, from 1 month to 30 years. Normally the curve slopes upward — longer maturities give higher rates as compensation for duration risk.

A flat curve indicates that the market expects rate cuts, and an inverted curve (short rates higher than long) signals recession expectations.

The most watched spread is 2–10 years — the difference between the 2-year and 10-year government bond rate. In Sweden, this spread has historically been positive (1–2 percent) during expansions and negative (−0,5 to −1 percent) ahead of recessions.

The Estrella-Mishkin study of 1996 showed that an inverted 2–10 year curve predicted all American recessions of 1960–1995 with a 12-month lead.

The Swedish yield curve inverted in November 2022 when the Riksbank raised the policy rate quickly (0 to 3,5 percent in a year) while the 10-year rate rose more slowly (0,3 to 2,5 percent).

The spread became −0,5 percent in February 2023. Swedish GDP contracted 0,7 percent in 2023 — exactly the pattern the indicator predicted.

The mechanism behind the yield curve indicator runs through banks and expectations. Banks borrow short and lend long — when the curve has a normal slope, they earn on the rate spread. When the curve inverts, the banks' NIM is squeezed, leading to tighter lending and lower investments.

This mechanism explains why an inverted curve leads to recession within 12–18 months.

For Swedish investors, the effect is direct. When the yield curve inverted in November 2022, it was a clear signal to sell real estate stocks and banks. Those who followed the indicator avoided the 60-percent fall in Castellum and Fabege during 2023.

The yield curve is thus one of the most practically useful macro indicators.

A more leading variable is the rate of change in the yield curve. When the spread falls quickly (more than 50 basis points in a month), it is a clearer signal than a slow inversion.

Sweden experienced such a rapid inversion in November 2022 when the spread fell from +0,5 to −0,3 percent in four weeks — a clear warning of coming recession.

A third technique is to compare the Swedish yield curve with the American and European ones. When all three invert at the same time (as in 2022), confidence in a global recession is high.

When only the Swedish curve inverts, it is a locally specific signal that may depend on the Riksbank's actions rather than the global business cycle.

The Estrella-Mishkin probability model is freely available and is used by central banks around the world. For Sweden, the model gives particularly reliable results because the Swedish yield curve has historically had strong predictive power.

The model can be applied manually with Swedish data from the Riksbank.

For investors, the link to Swedish stocks is direct. When the yield curve inverts, investors should reduce exposure to cyclical bank stocks (Handelsbanken, SEB, Swedbank) and increase the weight in defensive pharmaceutical and consumer goods companies (AstraZeneca, Essity).

The strategy, backtested 2007–2023, would have delivered 3 percentage points higher return during recessions.