Yield Curve Inversions
The yield curve has inverted. If you haven't seen it on the news yet, you probably will soon. One of the more historically reliable recession indicators is now blinking a yellow light. The 2 year treasury yield is now higher than the 10 year treasury yield, which means the yield curve is inverted. So what does this entail? Why does this often precede a recession? And what makes this inversion so unique?
What is the yield curve?
To start, the yield curve illustrates the relationship between the interest rate (aka yield) and the time until U.S. Treasury bonds mature. Typically longer dated bonds command higher yields due to the additional risks investors must take on - it’s difficult to predict the future 5 years from now, it’s even more difficult 30 years from now. Hence, the additional yield (reward) investors receive for buying longer dated bonds.
Why do inversions often precede a recession?
The yield curve is normally upward-sloping, because investors demand higher yields as they are asked to assume incremental maturity and inflation risk for investing in longer-term bonds. As recessionary environments tend to be deflationary (prices and interest rates drop), investors tend to increase demand for longer-term Treasuries over shorter-term Treasuries, leading the curve to invert (supply and demand affect the prices of bonds and other investments just like any other items in our daily lives).
Why is this inversion unique?
As Bloomberg highlights in the following article, this inversion is unique. The attention garnered by yield curve inversions is warranted as they often precede a recession but not all inverted yield curves lead to a recession. It’s not being caused by investor demand driving longer-term treasury yields down – in fact, 10-year treasury yields have increased from 1.5% to 2.4% this year. Rather, it is inverting because shorter-term yields are rising even faster (with 2-year treasury yields increasing from 0.74% to 2.4%). Shorter dated yields are less determined by investors and more directly affected by Fed policy, which is now combatting inflation by raising interest rates.
Legacy’s Perspective
While Legacy is not downplaying the historical record of yield curve inversions and subsequent recessions, we also believe that extraordinary measures by central banks in recent years to hold down long-term interest rates to fuel the economy may be making the signal less reliable. As such, Legacy prefers to look at a mosaic of leading economic indicators; most of which point to continued expansion over the near-term. We acknowledge the uncertainty around the Ukraine war – and do not proclaim to have any sort of edge around predicting the outcome. We will continue to focus our efforts on the underlying fundamentals supporting economic activity.
Fed funds rate path
Bespoke Investment Group offers this chart showing the implicit expectation for the course of the fed funds rate over the next two years, using data from CME Group.
What Else We’re Reading
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