Yield Curve Confusion
A strong economy combined with the impact from a shortage of workers, continued supply chain issues, Covid lockdowns in China and the Russian invasion of Ukraine have together generated the highest levels of inflation in decades. In response, the Federal Reserve has begun to hike ultra-low interest rates and halt its aggressive bond purchases that were required to keep the economy afloat during the heart of the pandemic. Consequently, bond yields have risen across the entire spectrum of maturities, some more than others. Interpreting those changes in yields, and what they may be telling us, has generated mixed signals about the outlook for the economy.
The yield curve plots the yield of different maturity Treasury securities ranging from one month to 30 years. In normal times, a longer-dated bond should have a higher yield than a shorter-dated bond, generating an upward sloping yield curve. Recently, we have experienced an inversion of various points on the curve as bond yields have broken out of a four-decade decline. Key portions of the curve inverting have often been precursors to the economy eventually moving into recession. Therefore, inversions attract considerable attention from economists and investors alike.
When the economy grows too quickly and demand exceeds supply, inflation results. The Fed then raises short-term interest rates to slow growth. However, investors predominantly determine the rates for longer maturities based largely on expectations of future levels of economic growth and inflation. That can create distortions and inversions in the yield curve where shorter maturities yield more than longer maturity securities.
The yield curve has recently been sending two different signals. The 2-year yield has intermittently exceeded that of the 10-year Treasury. While this inversion is no guarantee of a recession, it has preceded each of the past six recessions by 18 months on average. Interestingly, academic research supports using shorter parts of the yield curve to look for an inversion as a better indicator of near-term recession risks. This segment of the curve is more indicative of what the Fed has already done to slow economic growth, as opposed to the expectations built into the yield of the 2-year. By this measure, using the spread between the 3-month and 10-year Treasuries, the curve is still very steep and not currently flashing a warning about a possible impending recession.
It is important to note that an inverted yield curve does not cause a recession. Lower long-term rates indicate that investors believe inflation will be brought under control long before the bonds mature. That occurs in one of two ways: the Fed engineers a “soft landing” from higher inflation or excessively raises rates and pushes the economy into recession. In a “soft landing,” the Fed increases interest rates enough to cool off the economy and bring down inflation without driving up unemployment and causing a recession. Changes made by the Fed take time to filter through the economy, so they are done in stages to better gauge their impact and assess the need and scale of additional rate hikes.
The Fed has purposely been slower to react during the current cycle of monetary tightening. Its hesitancy has likely fostered higher near-term inflation, but also benefited the employment situation coming out of the pandemic by creating a greater demand for workers (the Fed has a dual mandate for both price stability and maximizing employment). By recalibrating slightly higher its medium-term inflation goal from 2% to 3% and by being more reactionary than proactive, it is also increasingly likely that the Fed won’t overtighten and push us into a recession. Historically, the Fed has a mixed record of pulling off these “soft landings” and this time the odds may be increasing of that occurring by maintaining a stronger economy and giving itself more leeway.
There is another major difference during this cycle. The Fed has acquired more than 25% of the U.S. Treasury market through its quantitative-easing asset purchases. They have ballooned the central bank’s balance sheet to almost $9 trillion, more than double the size of just two years ago. Hence, there are more factors at play with the curve than has been the case traditionally.
With the economy still robustly rebounding from the pandemic and the job market remaining so strong, it’s bewildering to think that we could be headed in the opposite direction anytime soon. Even with the Fed raising interest rates, we don’t believe a recession is on the horizon at this time. Despite the attention it attracts, it’s not as simple as saying an inverted yield curve means a recession is imminent.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
