Wall Street’s most talked about recession indicator is sounding its loudest alarm in two decades, raising investor concerns that the US economy is heading for a slowdown.
That indicator is called the yield curve, and it’s a way of showing how interest rates on various U.S. Treasuries compare., in particular, three-month bills and two- and ten-year Treasury bills.
Usually bond investors expect to be paid more if they lock in their money for a long time, so the interest rates on short-term bonds are lower than those on longer-term ones. Plotted on a chart, the different yields for bonds create an upward slope – the curve.
But occasionally, short-term rates rise above long-term rates. That negative relationship twists the curve into what’s called an inversion, indicating that normalcy in the world’s largest government bond market has been turned upside down.
Every U.S. recession in the past half-century has been preceded by an inversion, so it’s seen as a harbinger of economic doom. And it’s happening now.
The yield curve has a predictive power that other markets do not have.
On Wednesday, the yield on two-year government bonds stood at 3.23 percent, above the 3.03 percent yield on 10-year bonds. By comparison, a year ago, the two-year rate was over a percentage point lower than the 10-year rate.
The Fed’s mantra about inflation at the time was that inflation would be transient, meaning the central bank saw no need to raise interest rates quickly. As a result, shorter government bond yields remained low.
But over the past nine months, the Fed has become increasingly concerned that inflation will not slow down on its own and has begun to address rapidly rising prices by raising interest rates quickly. Next week, when the Fed is expected to raise rates again, its key rate will have risen about 2.5 percentage points from near zero in March, pushing up yields on short-term government bonds, such as the two-year bond.
Investors, on the other hand, have become increasingly concerned that the central bank will go too far and slow the economy to the point of causing a serious downturn. This concern is reflected in falling longer-term government bond yields, such as the 10-year, which tell us more about investor growth expectations.
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Such jitters are reflected in other markets as well: US stocks have fallen nearly 17 percent so far this year as investors reassess companies’ resilience to a slowdown in the economy; the price of copper, a global measure for its use in a range of consumer and industrial products, has fallen more than 25 percent; and the US dollar, a haven in times of concern, is at its strongest in two decades.
What sets the yield curve apart is its predictive power, and the recession signal it is now sending out is stronger than it has been since the late 2000s, when the technology stock bubble began to burst and a recession was only a few months away.
That recession hit in March 2001 and lasted about eight months. By the time it started, the yield curve had already returned to normal as policymakers had begun cutting interest rates to try to get the economy back on track.
The yield curve also predicted the global financial crisis that began in December 2007, initially reversed in late 2005 and would remain so until mid-2007.
That track record is why investors in the financial markets have taken notice now that the yield curve has inverted again.
“The yield curve is not the gospel, but I think it is at your own risk to ignore it,” 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 commonly used part of the yield curve is the relationship between two-year and 10-year yields, but some economists prefer to focus on the relationship between three-month bill yields and 10-year bonds.
One of the pioneers of research into the predictive power of the yield curve belongs to this group.
Campbell Harvey, now an economics professor at Duke University, recalls being asked to develop a model that could predict U.S. growth when he did an internship at the now-defunct Canadian mining company Falconbridge in 1982.
Mr. Harvey turned 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 earned a Ph.D. candidate at the University of Chicago, that he had completed his research showing that three-month and 10-year yield inversions preceded recessions that began in 1969, 1973, 1980, and 1981.
Mr. Harvey said he preferred the three-month yields as they are close to current conditions, while others have commented that they are more in line with investors’ expectations of immediate changes in Fed policy.
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For most market watchers, the different ways of measuring the yield curve all point in the same direction, indicating slowing economic growth. They’re “different flavors,” said Bill O’Donnell, Citibank interest rate strategist, “but it’s all ice cream.”
The three-month interest rate remains below the 10-year rate. So this measure has not inverted the yield curve, but the gap between them has quickly narrowed as concerns about a slowdown have increased. On Wednesday, the difference between the two yields had fallen from more than two percentage points in May to around 0.5 percentage points, the lowest level since the pandemic-driven downturn in 2020.
The yield curve cannot tell us everything.
Some analysts and investors argue that the focus on the yield curve as a popular recession signal has been exaggerated.
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 recession after two-year yields rise above 10-year yields is 19 months, according to data from Deutsche Bank. But the range is 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 exploded as it repeatedly bought government and mortgage bonds to support financial markets, with some analysts claiming those purchases could distort the yield curve.
These are both points that Mr. Harvey accepts. The yield curve is a simple way to predict the trajectory for US growth and the potential for a recession. It has proven to be reliable, but it is not perfect.
He suggests using it in conjunction with surveys of economic expectations among chief financial officers, who typically pull back on corporate spending as they become more concerned about the economy.
He also pointed to corporate borrowing costs as an indicator of the risk investors experience when lending to private companies. Those costs tend to rise as the economy slows. Both measures currently tell the same story: the risk is increasing and the expectations for a slowdown are increasing.
“If I were back in my summer internship, would I just look at the yield curve? No,” said Mr. Harvey.
But that doesn’t mean it’s no longer a useful indicator either.
“It’s more than helpful. It’s very valuable,’ said Mr Harvey. “It is the duty of the managers of any company to view the yield curve as a negative signal and get involved in risk management. And also for people. Now is not the time to use your credit card on an expensive vacation.”