A trader on the floor of the NYSE
David Dee Delgado | Getty Images
The bond market is flashing a warning signal for the US economy.
This harbinger is known as the “inverted yield curve”. These bond market reversals have been reliable indicators of past recessions. Part of the yield curve is inverted on Monday.
However, an economic downturn is not guaranteed. Some economists consider the warning a false alarm.
Here’s what you should know.
What is an inverted yield curve?
Why is it a warning sign?
An inversion of the yield curve does not trigger a recession. Instead, it suggests bond investors are concerned about the economy’s long-term prospects, Roth said.
Investors pay most attention to the spread between 2-year US Treasuries and 10-year US Treasuries. This curve does not yet show a warning sign.
However, US 5-year and 30-year Treasury yields reversed on Monday for the first time since 2006 before the Great Recession.
“It doesn’t mean a recession is imminent,” Roth said of the reversals. “It just reflects concerns about the future economy.”
According to Roth, the two- and 10-year Treasury yield curves inverted before the last seven recessions since 1970.
However, the data suggests that a recession is unlikely to be imminent if one does occur. After the bond market inverted, it took an average of 17 months for a downturn to set in. (Roth’s analysis treats the double-dip recession of the 1980s as a downturn.)
There was a false alarm in 1998, she said. There was also a reversal just before the Covid-19 pandemic, but Roth said that could probably also be seen as a false alarm as bond investors could not have predicted this health crisis.
“It doesn’t always work, but it has a high success rate for pointing to a future recession,” said Brian Luke, head of fixed income for the Americas at S&P Dow Jones Indices.
interest and bonds
The Federal Reserve, the US Federal Reserve, has a major impact on bond yields.
The Fed’s policies (namely, its benchmark interest rate) generally have a greater direct impact on short-term bond yields compared to those on longer-dated bonds, Luke said.
Long-dated bonds do not necessarily move in line with the Fed’s benchmark (called the Federal Funds Rate). Instead, investor expectations for future Fed policy have more impact on long-dated bonds, Luke said.
The US Federal Reserve raised interest rates in March in a bid to cool the economy and curb inflation, which is at a 40-year high. It is expected that this will be the case many more times this year.
There is nothing magical about a yield curve inversion. It’s not a light switch that flicks.
Preston Caldwell
Head of US Economy at Morningstar
This has helped push up short-term bond yields. Long-term bond yields have also risen, but not as much.
The 10-year government bond yield was about 0.13% higher than the 2-year bond yield on Monday. The spread was much wider at the start of 2022 (0.8%).
According to market experts, investors seem to fear a so-called “hard landing”. This would happen if the Fed hikes rates too aggressively to tame inflation and inadvertently triggers a recession.
During downturns, the Fed lowers interest rates to boost economic growth. (Lowering interest rates lowers the cost of borrowing for individuals and businesses, while raising them has the opposite effect.)
So, an inverted yield curve suggests that investors are anticipating a recession in the future and are therefore pricing in the expectation of a longer-term Fed rate cut.
“It’s the bond market that’s trying to understand the future direction of interest rates,” said Preston Caldwell, Morningstar’s head of US economics.
Treasury bonds are considered a safe haven asset as the US is unlikely to default on its debt. Investors’ flight to safety (and thus greater demand) for long-dated bonds also serves to depress their yields, Luke said.
recession likely?
A recession is not a foregone conclusion.
It is possible that the Federal Reserve will calibrate its interest rate policy appropriately and achieve its “soft landing” objective, thereby lowering inflation and not causing an economic contraction. The war in Ukraine has complicated the picture and pushed up the prices of commodities such as oil and food.
Stock picks and investment trends from CNBC Pro:
“There’s nothing magical about a yield curve inversion,” Caldwell said, adding that it doesn’t mean the economy will contract. “It’s not a light switch that’s being flipped.”
However, many economists have adjusted their economic forecasts. JP Morgan puts the chance of a recession at around 30% to 35%, which is higher than the historical average of around 15%, Roth said.