No Mistaking Yield Curve Signal

A relief rally has amplified a market trend that tends to precede recessions

By IGOR GREENWALD Updated December 09, 2022

Close up of U.S. Treasury bonds

Douglas Sacha / Getty Images

U.S. government bonds rallied in the past month amid early indications that inflation may
have peaked.

Mortgage rates that spiked following interest rate hikes by the Federal Reserve have
pulled back, relieving pressure on the housing market.

Riskier corporate bonds have rebounded as well.

All that would qualify as indisputably good news but for the biggest Treasury yield curve
inversion—long a reliable precursor of U.S. recessions—in four decades.

Normally, investors demand higher rates for longer-term bonds than for shorter-term
ones to compensate them for the greater risk. But as the Fed hikes its benchmark federal
funds rate, shorter-term yields follow suit, while those on longer-dated bonds are
restrained by the growing risk of an economic slowdown.

KEY TAKEAWAYS

A relief rally in longer-dated bonds has deepened the inversion of the yield curve.
Yields on longer-dated U.S. Treasuries often fall below shorter-term yields ahead of a
recession.

The spread between the 2-year Treasury yield and the 10-year Treasury yield is now the
widest it's been in 42 years.

The yield curve was last this inverted in 1980, ahead of two recessions caused by rapid
rate hikes.

The more the longer-dated bonds rally, sending yields lower, the deeper the inversion
gets, since short-term rates have been anchored by expectations that the Federal Reserve
will raise the fed funds rate again, and will be slow to reduce it subsequently.

Since Nov. 7, the yield on the 10-year U.S. Treasury note has dropped to 3.48% from
4.22%. The 30-year Treasury bond has rallied even more dramatically, its yield down to
3.44% from 4.34% a month ago. The spread often used to assess yield curve inversion,
between the yields on the 10-year and 2-year Treasury notes, was -0.84 percentage points
on Dec. 7, compared with -0.50 a month earlier. The spread was positive as recently as
July 1, after inverting briefly in April.

10-year Treasury yield minus 2-year Treasury yield chart

The yield curve's warnings about tough times ahead have found a receptive audience:
42% of U.S. adults say the economy is already in a recession, and another 35% expect a
contraction within a year.

Recent surveys of consumers, investors, and CEOs reveal similarly downbeat views on
the economy's direction.

A recent decline in leading economic indicators has only reinforced the pessimism.

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Yet there's also a counter-narrative: The economy still shows plenty of strength.

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The job market has stayed hot even as inflation starts to come down.

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Corporate profit margins remain near historic highs.

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Housing prices have cooled a bit: While the CoreLogic S&P Case-Shiller Index rose
more than 10% year-over-year in September, it's declined 3% from June's peak.

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Even so, everyone from Fed Chair Jerome Powell to retail investors pumping billions into
bond ETFs expects things to get worse before they get better.

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"Monetary policy affects the economy and inflation with uncertain lags, and the full
effects of our rapid tightening so far are yet to be felt," Powell said last week.

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While nothing is guaranteed, not even a recession, the Fed's aggressive rate hikes have
people looking back at the yield curve inversion that preceded the deep recessions of the
early 1980s as the Paul Volcker Fed quashed high inflation. This time around, the yield
curve inversion hasn't been as severe.

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Recessions often prove more painful than anticipated because they can be self-
reinforcing: Job losses reduce demand, spurring additional layoffs, for example. The
extent of a recession depends on the scale of the economic imbalances that cause them.

That leaves room for optimism that if a recession does arrive next year, it won't be severe.
While house prices rose sharply in the wake of the pandemic amid low interest rates, the
gains also reflect a tangible long-term housing shortage that's likely to persist.

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While consumer borrowing has increased recently, consumer debt remains historically
low relative to incomes.

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And the unusually low U.S. unemployment rate is the result of a post-pandemic wave of
early retirements that doesn't appear likely to reverse, as Powell noted.

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Yield curve inversions tend to end before recessions start. By then, the Fed is often
cutting rates. If it starts doing that again as joblessness spreads and growth reverses, we
may look back on this time fondly.

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