US Treasury Curve Recession Indicator Flashing Red

Even as stock investors cheer signs of peak inflation, the bond market’s best-known recession predictors are showing the clearest signal yet that trouble lies ahead for the US economy.

It is known in Wall Street lingo as an inverted yield curve, and in recent days has moved to its most extreme level since the 1982 recession thanks to a large drop in long-term bond yields. While this dynamic has existed in the last two decades, in each case there has been a recession. (For a look at the history of yield curves and recessions, see our previous story Here you go.)

While the inverted US Treasury yield curve is not known as a predictor of how deep or how long a recession can last, or even when a recession will begin, market watchers say the current message is unmistakable.

“Historically, when you get a sustained inversion like this … it’s a very reliable indicator of an impending recession,” said Duane McAllister, senior portfolio manager at Baird Advisors.

That left many market observers saying the real question is not whether there will be a recession, but what it will look like. Will it be shallow or deep? Short or pulled out?

Money managers and economists wrestle with this question. Many say the outlook is highly uncertain against the backdrop of recent economic data painting a somewhat conflicted picture. On the one hand, inflation has begun to decline from 40-year highswhich should give the Federal Reserve the ability to slow the rate of interest rate increases.

However, inflation remains very hot despite the recent easing. At the same time, job growth and consumer spending remains steady. In fact, that Atlanta Fed’s GDPNow forecast, the economic growth estimate, is clocking at a very strong 4.2% growth rate for the fourth quarter. Those indicators show that the Fed cannot afford to stop raising rates too early and risk introducing higher inflation into the economy, analysts said.

A line chart showing the US treasury yield curve.

What Is a Treasury Yield-Curve Inversion?

The US Treasury yield curve is basically a visual way of depicting the yields on a range of bonds issued by the US government, from Treasury bills to 30-year bonds. The most common way to look at the yield curve is to plot the yield from the two-year U.S. Treasury note to the yield on the 10-year U.S. Treasury bond.

Most of the time, the yield on long maturities is higher than the yield on short-dated bonds, which represents a greater risk of holding bonds for a long period.

In certain situations, such as what is happening now, the shape of the yield curve can flip with short-term yields rising above long-term yields. It is known as an inverted yield curve.

This year, the combination of the Federal Reserve increase in the federal-funds target rate and expectations for continued rate hikes has raised short-term US Treasury yields higher than long-term rates. (Fed-fund rate is the interest rate for overnight lending between banks.) The Fed has been aggressively raising interest rates with the goal of slowing the economy in order to take inflation from 40-year highs north of 8% down to the target. of 2%.

The message from the inverted yield curve is that while interest rates are high at the moment, in the future, economic growth will be slower and inflation will be lower. It has historically generally taken recessions to be the case.

How Does an Inverted Curve Work?

Since the beginning of July, the yield on the two-year record of the US Treasury has been higher than the 10-year record, and over the course of the summer and into the fall the gap has been widening. At the end of October, the two-year US Treasury note yielded 4.51%, up from 0.73% at the end of 2021. Meanwhile, the 10-year US Treasury note was at 4.10%, up from 1.52% on December 31. .

Jan Nevruzi, US rate strategist at NatWest Markets, says one key reason that long-term interest rates have been able to fall is that investors believe that the Fed will succeed in reducing inflation. “Inflation expectations are still quite anchored,” he said.

This trend was turbocharged after the October Consumer Price Index and Producer Price Index reports, which appear to have confirmed that inflation has peaked and started a downward trend. That led to a jump in bond prices — and a drop in yields — with dramatic moves among long-dated and long-dated bonds. The yield on the 10-year note fell to 3.67% on November 16, while the yield on the two-year note fell to 4.35%.

The rapid decline in yields among long-term bond yields than on short-term bonds means that the gap between the two-year note and the 10-year note has widened out negative 0.68 percentage points. The last time this curve was inverted was in October 1982, when the US economy was in the middle of a roughly one-year economic downturn.

In another measure of the yield curve, comparing yields from the three-month US Treasury bill to the 10-year note, the yield curve inverted by 65 basis points, the largest inversion for this measure since before the 2001 recession.

“The market is starting to have a little bit of disinflation euphoria,” said Alexandra Wilson-Elizondo, head of multi-asset retail investment at Goldman Sachs Asset Management, adding that she believes that the market is currently underestimating how long the tightening cycle by the Fed will last. will continue.

A line chart charting the spread between US 10-year and 2-year yields, and 10-year and 3-month yields.

How Bad is a Recession?

Given the warning signs, and months of discussion in the market about the potential for a recession—which is generally defined as two consecutive quarters of negative economic growth—should one occur, there is little reason for investors to be surprised.

“This will be the most anticipated recession in history,” said John Linehan, portfolio of US large-cap equity income strategies and chief investment officer at T. Rowe Price.

Preston Caldwell, chief US economist at Morningstar, said it is still a coin flip in terms of whether the economy will end up in an official recession. But, more importantly, he says, “We have consistently argued that the binary question ‘Will there be a recession?’ miss the point; any recession should be relatively mild and short, in our view.

Baird’s McAllister said a look at economic fundamentals suggests the decline won’t be too deep. “You have a household in good condition,” he said. “People don’t overindulge and if home values ​​go down, there’s a lot of equity there.” Additionally, corporate balance sheets are healthy and at the state and local government levels, public finances have “never looked better, with strong tax revenues …

At Goldman Sachs Asset Management, Wilson-Elizondo says the jury is still out when it comes to the kind of landing the economy experiences as a result of the Fed’s aggressive interest rate hike. “There are some real wild cards that haven’t been resolved,” he said.

One is the impact of the Fed loosening its hold on bond purchases made during the COVID-19 recession to pump money into the financial system and support the economy. (This effort by the Fed is generally known as quantitative tightening.) The second is the speed of reopening the Chinese economy from the strict “zero-COVID-19” policy, which, depending on the speed and timing, could provide a boost to the global economy and also elevate commodity inflation. .

In the US economy, Wilson-Elizondo says they focus on three variables in the job market to help understand whether there will be a hard landing or a soft landing: the ratio of job openings to job seekers, the rate of worker participation in the job market, and the overall rate of job creation.

How Much Will Inflation Go Down?

When it comes to the outlook for inflation, the focus in the market in the recent week has been in the direction that the inflation rate has taken: down. But Wilson-Elizondo says what matters more is where the inflation rate actually ends up. As of October, the CPI posted an annual increase of 7.7%.

“We focus a lot on the clear level rather than on the route,” he says. “But in terms of the path, the speed at which (inflation falls) is very critical.” For now, he said, what seems clear is that it’s hard to see inflation falling to the Fed’s 2% target level anytime soon, and, “We think they should stay tight.”

At NatWest, Nevruzi said they were looking for a recession starting at the end of this year, led by reduced consumer spending, “but not like a collapse where you see activity being halted.” Instead, he said, “We see the economy tipping into recession, more than a gradual slide, and a gradual return to 2024.”

Against this background, NatWest expects a gradual decline in inflation in 2023, but with the CPI remaining above the annual rate of 4% until the middle of 2023 and only reducing below 3% by the end of the year. Some slow-moving components such as rental costs or service prices such as airfares will help keep inflation on the “slow path,” he says. “That’s why we think that the Fed will increase to 5% (from the current target of 3.75%-4%) and stay at 5% until the end of the year,” he added.

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