2-year and 10-year Treasury yields reversed for the first time since 2019 on Thursday, sending a possible warning sign that a recession may be on the horizon.
The bond market phenomenon means that the interest rate on the 2-year bond is now higher than the yield on the 10-year bond.
This part of the yield curve is the most closely watched and is typically the one most convinced by investors that the economy could be headed for a downturn if it reverses. The 2-10 year spread was last in negative territory in 2019 before pandemic lockdowns sent the global economy into a severe recession in early 2020.
The 10-year Treasury yield fell to 2.331%, while the 2-year Treasury yield was 2.337% in late trading on Thursday. After a brief inversion, both yields were basically trading at the 2.34% level in the last trade.
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When the curve inverts, “there was a more than two-thirds chance of a recession sometime in the next year and a more than 98% chance of a recession sometime in the next two years,” according to Bespoke.
Some data providers showed the 2-10 spread technically inverted for a few seconds earlier Tuesday, but CNBC data has not confirmed the inversion as of yet. And of course, many economists believe that the curve must remain inverted for a significant amount of time before it gives a valid signal.
In general, the importance of the yield curve is easy to see when you think about what it means for a bank. The yield curve measures the spread between a bank’s cost of money and what it will earn by lending or investing it over a period of time. When banks can’t make money, lending slows and with it economic activity.
While the yield curve has provided reasonably reliable signals of imminent recessions, there’s often a long time lag, and analysts say there needs to be corroborating evidence before investors fear a recession is imminent.
Some of these other signals could be a slowdown in hiring and a sudden rise in unemployment, or early warnings in ISM and other data that manufacturing activity could be slowing. Analysts say the yield curve inversion could also reverse if there is a solution to the war in Ukraine or if the Federal Reserve pauses in its rate-hiking cycle.
According to MUFG Securities, the yield curve inverted 422 days before the 2001 recession, 571 days before the 2007-2009 recession, and 163 days before the 2020 recession.
“Most of the time it’s a harbinger of a recession, but not always,” said Julian Emanuel, head of equity, derivatives and quantitative strategy at Evercore ISI. He noted that it came once in 1998 during Russia’s debt crisis, which was followed by the failure of Long Term Capital Management, when the curve inverted but the economy avoided a recession.
“The beauty of the last 30-year history is that there have been so few recessions that you don’t want to say something is a golden rule, especially when there isn’t enough observation and that rule makes a big difference,” he said he called.
Bespoke notes that after six instances of 2-year and 10-year yield reversals since 1978, the stock market has continued to perform positively. The S&P 500 was up an average of 1.6% a month after the inversions, but was up an average of 13.3% a year later.
“Basically what happens over the long term is that in most cases there is a recession, but often it’s six to 18 months away and the stock market doesn’t peak until between two and 12 months before a recession begins.” Emanuel said, “Again, while the likelihood of a recession in Europe has become a baseline scenario, that is not the case for the US.”
Evercore sees a 25 percent chance of a US recession.
Because the Federal Reserve has become such a big player in the market, some bond pros don’t believe that yield curve inversion is as reliable a predictor of a recession as it used to be. The Fed’s nearly $9 trillion balance sheet includes many government bonds, and strategists believe it has pushed interest rates down at the long end, meaning yields on the 10-year note and the 30-year bond should be higher.
In fact, Richard Bernstein Associates notes that the 10-year yield could be closer to 3.7% if the Fed had never implemented quantitative easing. Without the central bank’s asset purchase program, the 2-year and 10-year yield curves would be 100 basis points apart, rather than inverted. (1 basis point equals 0.01%).
Strategists say the 2-year yield has risen the fastest because it’s the part of the curve that most closely reflects Fed rate hikes. The 10-year bond is also up against the Fed but was also held back by flight-to-quality trades as investors eye the war in Ukraine. Yields move inversely to price.
Some market pros believe the 3-month yield to 10-year yield is a more accurate recession forecaster, and that curve hasn’t flattened at all. This range has widened, signaling better economic growth.