I. Historical Correlation Between Yield Curve Inversion and Recession

The inverted yield curve has long been considered a key predictor of U.S. economic recessions. Historical data shows that since 1960, yield curve inversions have preceded nearly every recession. Following a partial recovery in 2022, the U.S. economy has been primarily driven by the Federal Reserve's continued interest rate hikes and balance sheet reduction.

Given similar historical patterns, markets have closely watched the yield curve inversion, interpreting it as signaling an imminent recession. However, contrary to expectations, from 2023 through Q4 2024, the U.S. economy has outperformed expectations, with recession risks steadily declining and growth likely to continue. This performance clearly diverges from the traditional warning signal of yield curve inversion, prompting questions about whether this relationship is changing.

II. Modern Factors Influencing Yield Curve Inversion

1. Fed Transparency and Forward Guidance
   Since 2012, the Federal Reserve has published dot plots projecting future interest rate paths, enhancing market understanding of policy direction. This has improved accuracy in short-term rate (e.g., 2-year Treasury) predictions, making yield curve inversions more likely.
2. Quantitative Easing Effects
   Following the 2008 financial crisis, the Fed's large-scale Treasury purchases depressed long-term rates, causing them to lag behind short-term rate increases. In practice, lower long-term rates and stable expectations for future demand for long-dated bonds have meant that during rate hike and balance sheet reduction periods, long-term rates haven't risen as sharply as short-term rates, contributing to yield curve inversion.

III. How Financial Market Evolution Affects Yield Curve Inversion

1. Banking Sector Structural Adaptations
   Recent years have seen U.S. banks' net interest margins (NIM) affected by credit regulation policies. Post-crisis, banks have focused more on liability duration structures. New liquidity rules encourage banks in high-rate environments to use stable deposits as liabilities, increasing sensitivity to rate changes while enhancing resilience.
2. Rising Importance of Non-Bank Financial Institutions
   Non-bank financial institutions have rapidly expanded post-crisis, becoming crucial funding channels. For instance, money market funds have remained competitive during rate hikes due to their shorter asset durations, complementing bank credit.

IV. Corporate and Household Adaptation Strategies

1. Corporate Financing Structure Shifts
   U.S. companies have significantly shifted toward equity financing over debt, reducing sensitivity to rate changes. With stronger liquidity positions and more flexible business models developed in anticipation of downturns, corporations are better equipped to weather economic volatility.
2. Household Financial Management
   Post-2008 crisis, U.S. households have prioritized liquidity management. During rate increases, they've responded by boosting fixed-income assets while reducing liabilities. This strategy has decreased interest rate dependence while improving housing market stability.

V. Conclusion

While the predictive power of yield curve inversion has weakened amid changing policy and market conditions, it remains an important economic indicator. The market response to the most prolonged inversion on record suggests that even if recession is avoided, future U.S. growth may still trail historical levels. All stakeholders should remain vigilant to potential economic risks and shifts.