There’s plenty for investors and observers of the U.S. economy to worry about these days: inflation spiking at the highest pace in 40 years, a land war on the continent of Europe, an aggressive Federal Reserve hiking interest rates and political deadlock in Washington.
And then there’s the yield curve.
The curve is actually a line that measures the yield of various durations of bonds. In normal times, the line should curve upward as yields go higher the longer the term of the bond, reflecting the greater risk of the unknown. Shorter-duration bonds, such as the 2-year Treasury note, should yield less than the 30-year bond.
But last week, the 2-year had a yield higher than that of the 10-year. That means the yield curve was inverted.
Why Does This Matter
Inverted yield curves reflect uncertainty about the future course of the economy and often serve as a warning sign of a coming recession, but not always. And it’s not a timing signal per se, as the curve can remain inverted for quite some time before a recession occurs. Occasionally, it can prove wrong. And, in the case of the 2/10 curve last week, it reverted back within the space of a day before inverting again.
Still, there’s no denying that bond investors are spooked, primarily by the stubbornness of consumer inflation that a year ago Federal Reserve Chairman Jerome Powell and economic advisers to President Joe Biden were describing as “transitory.”
The proximate cause for the inversion was a speech on March 21 where Powell sounded more hawkish than he had previously. The speech followed the Fed’s first rate hike in four years, when it raised rates 25 basis points in mid-March.
“We will take the necessary steps to ensure a return to price stability,” Powell told the audience of business economists. “In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
That signaled to bond traders that the Fed would move in May to raise rates by 50 basis points and that it will face difficulties trying to engineer a “soft landing” for the economy that averts a full-blown recession.
“I think the bigger worry is that the Fed kills off this economy,” says Megan Greene, chief global economist for the Kroll Institute and a senior fellow at the Kennedy School at Harvard University.
Which Yield Curve Matters
Last week, the market was focused on the disparity between the yield on the 2-year and the 10-year Treasury. That makes sense, as traders have a short-term horizon. Monday morning, the yield on the 2-year was 2.44%, while the 10-year was 2.391% – a slight inversion.
But others and, notably, the Fed tend to pay attention to other yields, those of the 3-month and 10-year Treasuries, for example. Right now, the yield on the 3-month is 0.533, well below the 10-year’s 2.391 – no inversion there.
Some, including Powell, cite a more granular reading, focusing on the shortest part of the curve, as he said in response to a question after his speech on March 21.
“Frankly, there’s good research by staff in the Federal Reserve system that really says to look at the short – the first 18 months – of the yield curve,” Powell said, according to Bloomberg. “That’s really what has 100% of the explanatory power of the yield curve. It makes sense. Because if it’s inverted, that means the Fed’s going to cut, which means the economy is weak.”
So far, that one is currently showing no inversion.
Strategists at BCA Research analyzed the various yield curves last week and while they concluded that inversion is a reliable recession indicator, it included some caveats. BCA branded the measure Powell cited as the Fed Slope.
“The 2-year/10-year Treasury slope has inverted in advance of 7 of the past 8 recessions and has not sent a false signal,” the report said. “The 3-month/10-year Treasury slope has done even better, calling 8 out of the last recessions without a false signal. The Fed Slope, meanwhile, has also called out 8 of the past 8 recessions, but it sent one false signal in September 1998.”
No matter which one people choose to focus on, an important consideration is that yield curve inversions can mean a recession will occur. But when they occur can vary substantially, and the economy and markets can often continue to be positive for some time.
“Over the last six economic cycles in the U.S., the 2yr-10yr spread inverted for the first time 18.6 months before the beginning of the next recession on average,” Jason Pride, chief investment officer of private wealth and Michael Reynolds, vice president of investment strategy at Glenmede Trust, wrote on Monday. “The spread between 3mo and 10yr Treasuries has a modestly better track record, leading recessions by 17.3 months on average.”
The pair said their firm’s model currently suggests the chance of a recession over the next 12 months is low, at less than 10% probability.
“However, the main risk to the outlook would be aggressively hawkish monetary policy, so the Fed should tread carefully along its tightening path,” they added.
Has the Pandemic Skewed Matters
The coronavirus caused a dramatic shock to the economy, leading to the sharpest but also shortest recession on record. Some point to the yield curve inversion in 2019 as proof of its accuracy in that a recession did follow in 2020, but that was brought on by the unusual nature of the pandemic as countries around the globe participated in a synchronized shutdown. It is possible there would have been no recession had the pandemic never occurred.
Then there is the unprecedented nature of the response to the pandemic, with the Fed buying up trillions in bonds and other securities to keep interest rates at historic lows and maintain the stability of financial markets. Did the Fed’s actions create a distortion in the bond market.
John Mousseau, president, CEO and director of fixed income at Cumberland Advisors, notes that before the coronavirus arrived in the U.S. the 10-year Treasury yield was 1.9%. Then, it reached a low of 0.5% in August 2020 as the economy struggled.
“So, when compared to (the 1.9%), a 60-basis-point rise in rates seems more reasonable, particularly given that inflation has risen (though we also think we will see some retreat in inflation later in the year),” Mousseau added.
He also points out that market rates were already on the rise before the Fed moved in March, undercutting the notion that the recent uneasiness in the bond market is all a reaction to the central bank’s actions.
“We don’t think this is as much the market front-running the Federal Reserve as it is a reversion to the mean after COVID,” Mousseau added.
The Curve May Serve Economists More Than Investors
One key factor in any yield curve inversion is that, while it can often forecast darker days ahead for the economy, it is not a sell signal for those who invest in stocks.
“What should matter most for investors is the signal that the curve can give for markets,” Glenmede’s Pride and Reynolds said. “Over these last six (economic) cycles, the S&P 500 actually posted positive returns between inversion and the actual beginning of recession in the U.S.”
For now, inflation and its direction is probably something to worry more about than the fact the yield curve may be inverted.
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