The yield curve is accelerating towards inversion — here’s what investors need to know

The bond market’s most reliable measure of the US economic outlook over the past half-century is heading for inversion at a faster pace than it has in recent decades, raising new concerns about the economic outlook as the Federal Reserve begins to aggressively consider to raise interest rates. .

The widely followed spread between 2-year-old TMUBMUSD02Y,
and 10-year government interest rates TMUBMUSD10Y,
shrank to as little as 13 basis points on Tuesday, the day after Fed Chairman Jerome Powell opened the door to raise benchmark interest rates by more than a quarter percentage point at a time. Although slightly higher on the day from Tuesday afternoon, the spread has fallen from as high as 130 basis points in October last year.

Investors are very aware of the Treasury’s yield curve or the slope of market-based returns across maturities due to its predictable strength. An inversion of the 2s / 10s has signaled any recession in the last half century. This is true of the early 1980s recession that followed the former Fed chairman Paul Volcker’s anti-inflationary efforts, the early 2000s downturn marked by the bursting of the dotcom bubble, the 9/11 terrorist attacks and various corporate accounting scandals, as well as 2007-2009 Great Recession triggered by a global financial crisis, and the short 2020 contraction driven by the pandemic.

Inversions have already hit other places along the US financial curve, suggesting that the momentum is expanding and may soon hit the 2s / 10s. The spreads between the 3-, 5- and 7-year government interest rates versus the 10-year ones, together with the difference between 20- and 30-year interest rates, are now all below zero.

“The yield curve has the best track record in financial markets in predicting recessions,” said Ben Emons, CEO of Global Macro Strategy.
at Medley Global Advisors in New York. “But the psychology behind it is just as important: People are starting to recognize interest rates that may be too restrictive for the economy and that could lead to a downturn.”

The following chart, compiled in February, shows how 2s / 10s inverted prior to previous recessions and have continued to flatten out this year. The 2s / 10s returned most recently for a short period in August and September 2019, just months before a downturn triggered by the COVID-19 hit in February to April the following year.

Source: Clearnomics, Federal Reserve, major global investors. Data pr. February 9, 2022.

Usually, the curve slopes upwards when investors are optimistic about the outlook for economic growth and inflation, because buyers of government debt typically demand higher interest rates to borrow their money over longer periods.

The opposite is also the case when it comes to a flattening or inverting curve: 10- and 30-year yields tend to fall or rise at a slower pace compared to shorter maturities, when investors expect growth to cool. This leads to decreasing spreads along the curve, which can then lead to the spread falling below zero in what is called an inversion.

A reverse curve can mean a period of poor returns on equities and hit banks’ profit margins because they lend cash at short interest rates while lending for longer.

Although it got a bit steeper on Tuesday, the 2s / 10s spread is still flattening out at a faster pace than it has been at any time since the 1980s and is also closer to zero than at similar times during previous Fed- rate hike campaigns, according to Emons of Medley Global Advisors. Normally, the curve does not approach zero until the interest rate hikes are well underway, he says.

The Fed delivered its first rate hike since 2018 on March 16 and is now preparing for a 50 basis point move as early as May, with Powell saying on Monday that there was “nothing” that would prevent such a move, even if no decision was made. yet.

Some market participants are now recognizing a Fed-fund interest rate target that could eventually exceed 3% from a current level between 0.25% and 0.5%.

Meanwhile, Powell says the yield curve is just one of many things politicians are looking at. He also cited Fed research, which suggested that spreads between the rates in the first 18 months of the curve – which are currently steeping – are a better place to look for “100%” of the curve’s explanatory power.

Sources: Bloomberg, Deutsche Bank

However, it is the 2s / 10s spread that comes with a documented track record from half a century. And it is fair to say that when the spread is about to reverse, observers have cast doubt on its predictive power.

Read: Here are three times where the Fed rejected the yield curve’s recession warnings and made mistakes (April 2019)

“Usually, the yield curve is an excellent look into the not-so-distant future,” said Jim Vogel of FHN Financial. “Right now, though, there are so many things moving at the same time that its accuracy and clarity are starting to diminish.”

One factor is “terrible” financial market liquidity as a result of the Fed’s move away from quantitative easing, as well as Russia’s invasion of Ukraine, Vogel said by telephone. “People don’t necessarily think. They react. People are not sure what to do, so they buy three-year maturities, for example, when people are typically more thoughtful about their choices. And those choices usually go into the accuracy of the curve.”

He sees the spread between 3-year-old TMUBMUSD03Y,
and 10-year dividends, which just reversed Monday after Powell’s comments, as a better prediction than 2s / 10s – and says a sustained inversion of 3s / 10s over one or two weeks would make him believe a recession is on the road .

On Tuesday, the Treasury continued to sell off sharply, pushing interest rates up over the basket. The 10-year interest rate rose to 2.38%, while the 2-year interest rate rose to 2.16%. Meanwhile, US equities regained ground as all three major indices DJIA,


rose in the afternoon trade.

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