What is a yield curve?
A yield curve is a graph that plots the yields of bonds with equal credit quality against their different maturities. Essentially, it shows the cost of borrowing money over different periods of time. The most commonly referenced yield curve is that for US Treasuries, which maps yields on US government debt ranging from one month to 30 years.
Usually, the yield curve is upward sloping from left to right, as investors require a higher return for locking up their money for a longer period of time given the greater uncertainty involved, in particular, the risk that inflation will eat in to returns.
Why is the yield curve making the news now?
The yield curve is in the news at the moment because part of the US Treasury curve recently became inverted, or downward sloping. In particular, the yield on the 10-year bond briefly fell below the yield on the 2-year note at the beginning of April1. In other words, the spread (or difference) between the two rates turned negative. This happened as the 2-year yield has jumped, reflecting the expectation that the US central bank, the Federal Reserve, will raise its official interest rate sharply during the coming months to rein in inflation. The yield on the 10-year bond, which is impacted more by investors longer-term expectations of interest rates, growth and inflation, has also risen, but not by as much.
This development has unnerved some investors because the yield curve has inverted prior to all previous US recessions since 1955, providing an early warning signal that an economic downturn is on the horizon2. The rationale for this phenomenon is that, in trying to bring inflation under control, the Fed will tighten policy too aggressively and end up pushing the economy in to recession. As a result, expectations grow that the Fed will ultimately be forced to cut interest rates at some point in the future to support the economy.
Following a yield curve inversion, when does a recession typically start?
There is a wide variation in the time between the 2s-10s spread turning negative and the onset of recession. The lag has varied between six months (prior to the 2020 recession) and 24 months (prior to the 1969 recession). The average for the last seven US recessions has been 16 months3.
Can a yield curve inversion actually cause an economic downturn?
This could be the case due to the impact on bank lending. As banks typically fund themselves at short rates and lend at longer-term rates, an inversion of the yield curve negatively impacts the profitability of making loans. As a result, banks might tighten lending conditions and grant fewer loans. In turn, this could cause the economy to slow and possibly fall into recession.
It should be noted, however, that there is not much sign that this is happening yet. The latest Senior Loan Officer Survey from the Federal Reserve showed banks continuing to ease lending standards4.
Moreover, some observers also point out that bank loans are not as important a source of credit in the economy as they used to be. According to Citigroup, bank loans currently make up about 30% of credit in the US economy compared with over half at the end of the 1970s5.
Are all parts of the yield curve sending a recession signal?
No. In particular, the spread between the 3-month rate and that of the 10-year note is still positive and has widened since the start of March6.
The difference comes about because the 2-year yield reflects expectations for future Fed rate hikes (the market sees the Fed raising its policy rate close to 3% during the next year or so7), while the 3-month rate remains anchored by the fact that the current policy rate is still low (the Fed funds target range is currently 0.25-0.5% after rates were hiked by 25 basis points in March8). Some see the 3m-10yr spread as a more reliable recession indicator that is less likely to give false signals9.
Indeed, Fed Chairman Jerome Powell has also suggested that the steepness of the short-term Treasury curve (specifically, the 3-month/18-month forward spread) is not consistent with the prospect of a pending recession10.
Are there any reasons why the 2s-10s inversion might be sending a less reliable warning signal this time around?
It is always risky to say that this time is different. However, several factors might suggest that the yield curve’s recession signal might be distorted in the current circumstances. One potential factor is that successive quantitative easing (QE, or bond buying) programmes by the Fed - both during the 2008-09 financial crisis and more recently during the coronavirus pandemic - have artificially depressed bond yields. With longer-term bond yields relatively low, it is easier for the curve to invert as the Fed raises short-term interest rates.
Similarly, some observers have argued that a downward revision in the Fed’s estimate of the neutral policy interest rate (i.e., the rate that neither boosts nor restricts the economy) over the last ten years has served to anchor long-term bond yields, resulting in a flatter yield curve which is more prone to inversion.
According to this reasoning, slower potential growth in the economy due to weaker productivity and demographic factors puts a limit on how high the Fed’s policy rate will rise over the long term, thereby limiting the extent to which long-dated bond yields will move higher. The Fed’s estimate of the neutral interest rate has fallen from 4.3% in 2012 to 2.4% currently11.
In addition, ultra-low bond yields in the Eurozone and Japan could also be depressing long-term Treasury rates given that US yields are relatively attractive to overseas investors from these regions. Strong demand for long-term bonds from pension funds looking to duration match their liabilities could also be keeping the yield curve flatter than it otherwise would be. These factors might mean that the yield curve carries less information regarding investor expectations about the outlook for the domestic economy than it once did.
Indeed, part of the reason why an inverted yield curve has signaled a pending recession in the past is because financial conditions were becoming too tight. For example, during the 2006-07 yield curve inversion, the Fed’s policy rate was above 5%12, which adjusting for inflation equated to a ‘real’ rate of over 2%13.
However, at the current juncture, the Fed’s policy rate is deeply negative in real terms and is a long way from becoming restrictive. According to Fed policymakers’ latest forecasts, the ‘real’ (i.e., inflation-adjusted) policy rate will only turn slightly positive towards the end of 202314.
Are any other indicators pointing to a pending recession?
Indications are that growth in US real GDP has slowed going in to 202215, but the economy is still relatively hot. The labour market is very tight, with job vacancies outnumbering the level of unemployment by about 5 million16 and the jobless rate, 3.6% in March, is now back to pre-pandemic levels17.
This would suggest there is little risk of the economy falling into recession anytime soon. However, it should be remembered that the unemployment rate is what economists call a lagging indicator (i.e., an indicator which tells us how strong or weak activity has already been). In this regard, it is worth noting that the unemployment rate generally stays low right up until the point a recession starts.
Some leading indicators (i.e., those that provide an advance warning of future strength in economic activity) have weakened in recent months. For example, gauges of new orders in the manufacturing sector18, as well as some measures of consumer confidence19, have turned down recently indicating a cooling in economic activity. However, they are not generally flashing red.
A sharp run-up in oil prices like we have seen over the last year has ushered in recessions in the past, not least as rising energy costs eat into household incomes. However, the fact that the US is now a net oil exporter and economic growth is less energy-intensive (due to efficiency gains and the growing importance of the service sector) has made the country somewhat less vulnerable in this regard.
How do US equities generally perform after a yield curve inversion?
They generally do well during the months after the 2s-10s spread turns negative. According to data from JP Morgan looking at the last six yield curve inversions, US large cap equities peak on average 11 months after the curve inverts, posting an average increase of 15% during this period. However, the variation in time lag is quite wide. The equity market actually peaked two months before the curve inversion of March 1973. In contrast, it was nearly two years (20 months to be precise) before the equity market peaked following the January 2006 inversion20.
In terms of sector performance, defensive sectors such as consumer staples and healthcare tend to outperform during the 12 months after an inversion, while sectors such as consumer discretionary and industrials (which are more sensitive to the economic cycle) tend to do less well21.
19th April 2022
1 https://fred.stlouisfed.org/series/T10Y2Y
2 https://www.reuters.com/business/finance/part-us-yield-curve-just-inverted-does-that-mean-recession-is-coming-2022-03-28/
3 JP Morgan – Yield curve signals for the stage of the cycle.
4 https://www.federalreserve.gov/data/sloos/sloos-202201.htm
5 https://www.washingtonpost.com/business/energy/banks-arent-sweating-a-yield-curve-inversion-yet/2022/03/30/fd7d984c-b010-11ec-9dbd-0d4609d44c1c_story.html
6 https://fred.stlouisfed.org/graph/?graph_id=1029425
7 https://www.atlantafed.org/cenfis/market-probability-tracker
8 https://www.cnbc.com/2022/03/16/federal-reserve-meeting.html
9 https://lplresearch.com/2022/04/06/10-things-to-know-about-inverted-yield-curves/
10 https://uk.news.yahoo.com/powell-backed-yield-curve-gives-144959691.html
11 https://fred.stlouisfed.org/series/FEDTARMDLR
12 https://fred.stlouisfed.org/graph/?graph_id=1024579
13 https://fred.stlouisfed.org/graph/?graph_id=1024607
14 https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20220316.pdf
15 https://www.atlantafed.org/cqer/research/gdpnow
16 https://www.cnbc.com/2022/03/29/there-are-now-a-record-5-million-more-job-openings-than-unemployed-people-in-the-us.html
17 https://fred.stlouisfed.org/series/UNRATE
18 https://www.ismworld.org/globalassets/pub/research-and-surveys/rob/pmi/rob202204pmi.pdf
19 https://fred.stlouisfed.org/series/UMCSENT
20 JP Morgan – Yield curve signals for the stage of the cycle.
21 https://financialpost.com/investing/david-rosenberg-how-key-asset-classes-performed-following-a-yield-curve-inversion