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Thursday, December 01, 2022

EXPLAIN: Why US bond yields could warn of recession

One of the more reliable warning signs of an economic recession is starting to shine. The “yield curve” is being watched for clues as to how the bond market feels about the US economy’s long-term outlook. On Tuesday, a cautious share of the yield curve gave investors cause for concern.

WHAT IS THE RETURN CURVE?

At the center of the investment world are Treasurys, the IOUs that the US government gives to investors who lend them money. The yield curve is a graph that shows how much interest different treasuries pay.

On the one hand, there are shorter-term treasuries, which are repaid over a few months or a few years. Returns closely follow expectations for what the Federal Reserve will do with overnight interest rates. On the other side of the chart are longer-term treasuries, which take 10 years or decades to expire. Their yields tend to move more on expectations for economic growth and inflation further into the future.

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Usually, longer-term treasuries offer higher returns than shorter-term ones, resulting in a chart with an upward sloping line. This is partly because investors usually demand higher returns to lock away their money for longer, given the possibility of future rate hikes by the Fed and the risk of inflation. But when investors worry that the economy will plummet sharply, perhaps because the Fed is pushing short-term rates too aggressively, they are willing to accept less for a treasury that matures many years into the future.

When yields for short-term treasuries are higher than yields for long-term, market viewers call it an “inverted yield curve.” And when that chart has a downward sloping line, Wall Street starts to get nervous.

WHY CARE?

All the talk about charts and returns is hard to digest, but an inversion in the yield curve is considered a reliable predictor of a recession. Wall Street tends to watch the ratio between two-year and 10-year treasury yields for clues as to whether the bond market is worried about an economic downturn, though it has sometimes reversed without a recession following.

Other market observers, including officials at the Federal Reserve, consider the ratio between the 3-month and 10-year treasuries to be the most important one. Every recession in the last 60 years has been preceded by an inversion of the yield curve between the three-month and 10-year treasury.

There is usually some delay between the two. According to the Federal Reserve Bank of Cleveland, one rule is that it takes about a year after the three-month treasury yield is the top 10-year yield before the onset of the recession.

WHAT HAPPENS NOW?

At 0.56%, the three-month return is still well below the 10-year return of 2.41%, so no inversion there.

But on Tuesday, for the first time since the summer of 2019, the two-year treasury yield briefly reached the 10-year yield for the first time. Other, less followed parts of the yield curve had already been reversed. Although they do not have such a good record of success in predicting recessions as the yield of three months versus the 10-year, they show the trend swinging towards pessimism.

The last time the two-year yield was above the 10-year yield, it took less than a year before the world economy plunged into a recession. At that time, however, the bond market did not see the pandemic coming. It was more concerned about global trade tensions and slowing growth.

Now the two-year yield is rising as investors raise expectations for a more aggressive Fed. The central bank has already pulled its key overnight rate from its record low, the first increase since 2018, in hopes of hitting high inflation. He is also preparing to raise rates several more times, and the Fed has indicated that he can do so by double the usual amount at some meetings. This has helped to more than triple the two-year yield in 2022 alone.

The 10-year yield also rose, but not as fast.

SO THE RETURN CURVE ONLY REFLECTS THE THOUGHT OF THE SECURITIES MARKET?

It can also have a real impact on the economy. Banks, for example, make money by lending money at short-term rates and lending it at longer-term rates. When that gap is large, they make more profit. However, an inverted yield curve complicates this. If it causes banks to cut loans – and therefore growth opportunities for companies – it could help tighten the brakes on the economy.

IS THIS A PERFECT FORECAST?

No, a reverse yield curve has previously sent false positives. The yields of three months and 10 years, for example, reversed in late 1966 and a recession only hit at the end of 1969. Some market watchers have also suggested that the yield curve is now less significant because the herculean actions by central banks around the world have distorted yields. Through the pandemic, the Federal Reserve bought trillions of dollars worth of bonds to keep long-term yields low, after lowering overnight rates to near zero. Soon it will start allowing those bonds to roll off its balance sheet, which should add upward pressure on longer-term returns.

SHOULD I PANIC?

Fed Chairman Jerome Powell would say no. Last week, he said he pays more attention to the first 18 months of the yield curve than what goes on between the two-year and 10-year returns. “It has 100% of the explanatory power of the yield curve,” he said, and it is not the other way around. “The economy is very, very strong,” he said, pointing to its continued growth and the healthy labor market.

And even if the two-year and 10-year treasury returns are reversed on Tuesday, it could end up being just a temporary slap rather than a lasting trend. However, many investors are becoming more concerned about the risk of a recession or the possibility of “stagflation”, which would be the painful combination of high unemployment and high inflation. Of course, the bond market also appears to be more pessimistic. Just look at the yield curve.

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