By Megan Davies and Ira Iosebashvili
NEW YORK (Reuters) – The U.S. Treasury yield curve is flashing a warning sign to Wall Street, where many are worried that a recession could be in store after bond investors pushed up short-term rates to the point where yields on the 2-year Treasury were actually higher than the 10-year Treasury.
Such a phenomenon, called a “yield curve inversion,” is a key metric that investors watch as bond yields impact other asset prices, feed through to banks’ returns and have been an indicator of how the economy will fare. Aside from signals it may flash on the economy, the shape of the yield curve has ramifications for consumers and business.
On Tuesday, one of the most closely-watched parts of the curve, the two-year to 10-year curve, inverted, sending a warning sign for investors that a recession could follow. The last time it inverted was 2019 and the following year, the United States entered a recession – albeit one caused by the global pandemic.
“A lot of people focus on this and there could be a self-fulfilling expectation, they see the 10 year/2 year invert and believe there will be a recession and change behavior,” said Campbell Harvey, Professor of Finance at the Fuqua School of Business, Duke University, who pioneered using the yield curve as a predictive tool for recessions. “So if you’re a company you cut back capex and employment plans.”
Harvey, who focused his research on a different part of the yield curve, added that being prepared for a recession was “not a bad thing… so when it occurs you survive.”
Broker-dealer LPL Financial said the 2/10 inversion is “a powerful indicator” pointing out that it predating all six recessions since 1978, with just one false positive.
“There is a reason this indicator is so widely followed,” those analysts said.
While investors caution that the yield curve is just one indicator among many to look for when predicting recession, the curve has become a classically followed signal.
“There is definitely a psychological element to it,” said Gennadiy Goldberg, senior rates strategist at TD Securities. “The yield curve has worked in the past because it has been a signal that the end of the cycle is coming.”
CLOSELY FOLLOWED
Yields of short-term U.S. government debt have been rising quickly, reflecting expectations of a series of rate hikes by the U.S. Federal Reserve, while longer-dated government bond yields have moved at a slower pace amid concerns policy tightening may hurt the economy.
As a result, the shape of the Treasury yield curve has been generally flattening and in some cases inverting.
Not everyone is convinced the curve is telling the whole story. Some say the Fed’s bond buying program of the last two years has inflated the price of 10-year Treasuries, keeping the yield artificially low. They say the yield is bound to rise when the central bank starts shrinking its balance sheet, steepening the curve.
Clouding the picture further is that different parts of the yield curve have been signaling different signs.
While financial markets see the two-year yield as a good proxy for Fed policy and closely follow the 2/10 part of the curve, many academic papers favor the spread between the yield on three-month Treasury bills and 10-year notes. This yield curve has not indicated recession.
Eric Winograd, senior economist, AllianceBernstein said discussion of the yield curve inversion was “overheated.”
“I understand the narrative and I think from a risk-taking perspective there is good evidence that a flat or inverted yield curve is a challenge for broader risk assets but I am not going to worry more about a recession if the yield curve inverts by 5 basis points or doesn’t,” Winograd said.
Investors may be more dismissive of an inversion this time around, as the Fed remains very early in the hiking cycle, with time to pull ease off the brakes if the economy appears to be slipping into a downturn, TD’s Goldberg said.
Researchers at the Fed, meanwhile, put out a paper https://www.federalreserve.gov/econres/notes/feds-notes/dont-fear-the-yield-curve-reprise-20220325.htm on March 25 that suggested the predictive power of the spreads between 2- and 10-year Treasuries to signal a coming recession is “probably spurious,” and suggested a better herald of a coming economic slowdown is the spread of Treasuries with maturities of less than 2 years.
Still, for some, the trend is not to be ignored.
“I’ve had a lot of questions about whether this time is different because of QE and other reasons keeping the term premium artificially flat, and thus reducing the recession signaling properties of 2s10s and other yield curve measures,” wrote Deutsche Bank’s Jim Reid.
“However, for me I think about it very differently. I don’t care why the curve inverts as I think the transmission mechanism is through animal spirits.”
(Reporting by Megan Davies, Ira Iosebashvili, Lewis Krauskopf and David Randall; writing by Megan Davies; Editing by David Gregorio)
