Wall Street’s most talked-about recession indicator is sounding the loudest alarm in two decades, adding to investor concerns that the US economy is headed for a slowdown.
This indicator is called the yield curve and shows how the interest rates of various US Treasury bonds compare, in particular, three-month bills and two-year and ten-year Treasury bills.
Typically, bond investors expect to be paid more for investing their money over the long term, so interest rates on short-term bonds are lower than longer-term ones. Plotted on a chart, the various bond yields form an ascending line – the curve.
But every now and then, short-term interest rates rise above long-term rates. This negative relationship distorts the curve into what is known as an inversion, signaling that the normal situation in the world’s largest government bond market has been turned on its head.
Every US recession over the past fifty years has been preceded by an inversion, seen as a harbinger of economic doom. And it’s happening now.
The yield curve has a predictive power that other markets don’t have.
On Friday, the two-year Treasury note yield was 2.97 percent, ahead of the 2.75 percent yield on the 10-year note. For comparison, a year ago, two-year yields were over a percentage point below ten-year yields.
The Fed’s mantra on inflation at the time was that it would be temporary, meaning the central bank saw no need to raise interest rates quickly. As a result, shorter-dated Treasury yields remained low.
But over the past nine months, the Fed has become increasingly concerned that inflation will not abate on its own, and has begun to counteract rapidly rising prices by rapidly raising interest rates. By next week, when the Fed is expected to hike rates again, its policy rate will have risen about 2.5 percentage points from near zero in March, and that has pushed yields on short-dated Treasuries like the 2-year bond higher.
On the other hand, investors are increasingly concerned that the central bank will go too far and slow down the economy enough to trigger a severe downturn. This concern is reflected in falling yields on longer-dated government bonds, such as 10-year government bonds, which tell us more about investors’ growth expectations.
8 signs the economy is losing momentum
Map 1 of 9
Worrying prospects. Amid persistently high inflation, rising consumer prices and falling spending, the US economy is showing clear signs of slowing, fueling concerns about a possible recession. Here are another eight actions that indicate upcoming problems:
consumer confidence. In June, the University of Michigan consumer sentiment survey hit its lowest level in its 70-year history, with nearly half of respondents saying inflation is eroding their standard of living.
The housing market. Demand for real estate has fallen and new home construction is slowing. These trends could continue if interest rates rise, and real estate companies including Compass and Redfin have laid off staff in anticipation of a downturn in the housing market.
Copper. A commodity that analysts see as a measure of sentiment for the global economy — because of its widespread use in buildings, cars and other products — copper has fallen more than 20 percent since January, hitting a 17-month low on July 1.
Oil. Crude oil prices have risen this year, in part due to supply constraints following Russia’s invasion of Ukraine, but have started to falter of late as investors worry about growth.
The bond market. Long-term government bond rates have fallen below short-term rates in an unusual event that traders are calling a yield curve inversion. It suggests that bond investors are anticipating an economic slowdown.
That nervousness is mirrored in other markets: Stocks in the United States have fallen nearly 17 percent this year as investors reassessed companies’ ability to weather a slowdown in the economy; as the price of copper, a global beacon due to its use in a range of consumer and industrial products, fell by approximately 25 percent; and with the US dollar, a haven in times of trouble, at about its strongest in two decades.
What sets the yield curve apart is its predictive power, and the recession signal it is currently sending is stronger than it has been since late 2000, when the bubble in tech stocks began to burst and a recession was just months away.
This recession started in March 2001 and lasted about eight months. When it started, the yield curve was already back to normal because policymakers had started cutting interest rates to try to get the economy back to health.
The yield curve also heralded the global financial crisis, which began in December 2007 and initially reversed in late 2005 and remained so until mid-2007.
This track record is why investors in the financial markets have become aware that the yield curve has inverted again.
“The yield curve isn’t gospel, but I think ignoring it is at your peril,” said Greg Peters, co-chief investment officer at asset manager PGIM Fixed Income.
But which part of the yield curve is important?
On Wall Street, the most frequently mentioned part of the yield curve is the ratio between two-year and 10-year yields, but some economists prefer to focus on the ratio between three-month and 10-year yields instead.
This group includes one of the pioneers of research into yield curve predictive power.
Campbell Harvey, an economics professor at Duke University, recalls being asked in 1982 to develop a model that could forecast US growth while he was on a 1982 summer internship at the now-defunct Canadian mining company Falconbridge.
Mr. Harvey turned his attention to the yield curve, but the United States had been in recession for about a year and he was soon fired due to the economic climate.
It wasn’t until the mid-1980s when he was getting his PhD. candidate at the University of Chicago for completing research showing that a reversal in three-month and ten-year yields preceded the recessions that began in 1969, 1973, 1980, and 1981.
Mr Harvey said he prefers to look at three-month yields because they are close to current conditions, while others have noted that they more directly reflect investor expectations for immediate Fed policy changes.
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For most market observers, the different methods of measuring the yield curve are broadly pointing in the same direction and signaling slowing economic growth. They’re “different flavors,” said Bill O’Donnell, a rates strategist at Citibank, “but they’re all still ice cream.”
3-month returns remain below 10-year returns. So this action has not inverted the yield curve, but the gap between them has been rapidly shrinking as concerns of a slowdown have escalated. As of Friday, the spread between the two yields had narrowed to less than 0.3 percentage point from over 2 percentage points in May, the lowest level since the pandemic-driven downturn in 2020.
The yield curve cannot tell us everything.
Some analysts and investors argue that attention to the yield curve as a popular recession signal is overdone.
A common criticism is that the yield curve tells us little about when a recession will start, only that there is likely to be one. The average time to a recession after 2-year yields have risen above 10-year yields is 19 months, according to Deutsche Bank data. But the bandwidth ranges from six months to four years.
The economy and financial markets have also evolved since the 2008 financial crisis, when the model was last in vogue. The Fed’s balance sheet has bloated as it has repeatedly bought Treasuries and mortgage bonds to prop up financial markets, and some analysts argue that these purchases can distort the yield curve.
These are both points that Mr. Harvey accepts. The yield curve is an easy way to predict the trajectory of US growth and the potential for a recession. It’s proven reliable, but it’s not perfect.
He suggests using it in conjunction with surveys of economic expectations among CFOs, who typically cut corporate spending when they are more concerned about the economy.
He also pointed to corporate borrowing costs as an indicator of the risk investors perceive when lending to private companies. These costs tend to increase when the economy slows. Both measures are currently saying the same thing: risk is increasing and expectations for a slowdown are increasing.
“If I was back on my summer internship, would I just look at the yield curve? No,’ said Mr Harvey.
But that doesn’t mean it’s stopped being a helpful indicator either.
“It’s more than helpful. It’s quite valuable,” Mr Harvey said. “It is incumbent upon the managers of any company to understand the yield curve as a negative signal and to manage risk. And also for people. Now is not the time to max out your credit card for an expensive vacation.”
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