The inversion of the yield curve is one of those events that have In past episodes, the mere inversion of the curve has triggered large corrections in world stock markets without a solid macroeconomic foundation (damage to the real economy or to the results of the companies) that justified them. when it comes to predicting recessions, it seems to be enough to generate panic among a part of the investors who sell their risky assets and take refuge in long-term sovereign debt (or other safe-haven assets). Now, some parts of the curve in the US, which has once again aroused some uneasiness among investors and analysts.
Put simply, the flattening of the yield curve means that the yield on short-maturity bonds (one-year or two-year bills or bonds) is approaching the 10-year bond yield, while investment of the curve occurs when short-term interest rates are higher than long-term ones (as has already happened with the 5-year bond).
The curve on the left is inverted and the one on the right has a normal slope.
The interest rate curve is formed by the maturities of the different bonds, which can range from one month to 30 years. In theory and under normal economic conditions, the yield on these bonds should increase as the maturity lengthens. When this does not happen it is because the curve (or a part of it) has been inverted.
Conversely, (the opposite of a flat or inverted curve) generally indicates expectations of stronger economic activity, higher inflation, and higher interest rates in the long run (a long and prosperous cycle of growth is anticipated). On the contrary, when the curve flattens the signal is the opposite: investors expect short-term rate hikes (the last hikes at the end of the cycle), but they expect/predict lower interest rates in the medium and long term. because they have lost confidence in the growth prospects of the economy. The inversion of the curve does not trigger the recession, it is rather an anticipated consequence of the downturn in the economy.
What is the curve telling us now?
For now, but nothing is closed yet, far from it: as of today only some specific parts have been invested. Although each master has his booklet, it is generally accepted that when all short-term bonds (especially one and two-year ones) outperform long-term bonds, the countdown to the next recession begins, at least that is what history says since the 50s.
The yield curve is close to inverting in the 2 and 10 year tranche
To date, only some parts of the curve have been inverted (5 and 30 years, for example), but the 2 and 10 year bond continues to show a slight slope (less and less), while the bills (with months or a year) and long-term bonds continue to show a very steep slope, which is generating some confusion and debate among economists: while some parts of the curve are inverted, others continue to predict solid growth. For this reason, a not insignificant part of analysts call for caution in the face of these anomalies and markets distorted by the central banks’ bond purchase programs. The debate is served.
Although it is true that the foregoing may mark differences with respect to past occasions, it is also true that, whenever the curve begins to flatten, a part of the analysts, central bankers and investors to try to convince public opinion that this time is different and that the curve is not forecasting the arrival of a recession.
For example, Juan J. Fernández-Figares, from Link Securities, comments that “traditionally, the fact that the yield of the US bond with a maturity of 2 years exceeds that of the bond with a maturity of 10 years has been considered as an alert signal However, when it comes to predicting a potential recession, we consider the fact that the curve inverts from the shortest-term yields to be more relevant, that is, that the yield of 1- or 3-month bonds is higher than that of 5- or 10-year bonds,” he points out.
For John Canavan, from Oxford Economics, there is extensive literature and empirical evidence that shows that the slope of the yield curve is a reliable predictor of economic activity and future recessions. So, he stresses, this year’s investment risks raise concerns about what it could mean for the economy in the future, as the Fed signals a much tougher policy stance.
However, explains the economist, although the inversion of the 2-year/10-year sector of the Treasury curve has preceded each of the last ten recessions -the only falsely positive reading was in 1965-1966-, the investigation of the Fed suggests that this spread may not be the best barometer of the curve when looking for signs of a recession. “Powel recently noted that Fed studies suggest watching the very short-term part of the curve, only up to the next 18 months. However, the predictive power of the short-term spread is limited as a forecasting tool.” assures Canavan.
From Citi they agree and dare to emphasize Powell’s ‘error’: “The president of the Fed is making a mistake when analyzing the yield curve and is ignoring that “From our point of view, Powell is putting too much faith in the yield curve wrong yields”. From Citigroup they calculate that the risk of a recession in the US in the next twelve months has increased to 20%, compared to 9% in February.
Jerome Powell and the Fed suggest that the 3 month/10 year spread provides more reliable information on changes in the business cycle. However, there are buts that Oxford Economics recounts: “The good news is that this differential is still significantly positive. That said, the main reason is that the 3-month Treasury bill rate is closely linked to real changes in the funds rate and does not reflect expectations of more rapid tightening by the Fed. As a result, Canavan concludes, “we don’t think signals from the 2-year/10-year spread can be ignored,” adding that the Oxford Economics model with that spread also shows increased recession probabilities over the next 12 months.
Is this time different?
The big problem, Canavan says, is when: “History shows that a reversal would not provide clear guidance on when a recession would occur.” Historically, the time between the spread inversion and the start of the recession has been long and variable. “For the five recessions prior to the brief covid-induced recession in 2020, the lead time between investment and the start of the recession was about 20.5 months. Also, the lead time range is quite wide, ranging from 9.5 months before the 1981-1982 recession to 35 months before the 2001 recession”, describes the economist.
“The historical pattern is that the inverted curve between 10 and 2 years preceded each recession, with a lag of between 6 months and 2 years, and rarely sent the wrong signal. However, a notable difference from the is that the flattening this time around has been driven by very aggressive Fed rate setting, while the curve between the shortest and 10-year rates remains steep.Historically, these two curves have followed one another, which is one of the reasons why we cannot be so concerned about the prospects of the US economy so far and – given the historical delay – especially for next year”, consider analysts from the Nordic bank SEB .
These experts also stress the role that Fed accommodation has played in suppressing long-term interest rate maturities. When the central bank goes on to reduce its balance sheet, they add, it will have good opportunities to raise long terms.
“The yield on five-year US bonds is higher than that on 30-year US bonds, which means that part of the yield curve has inverted. Do bond markets know something that economists don’t, that Do they indicate that a recession is now inevitable? No. Inversions of the curve signaled recessions in the 1970s, when bond yields were primarily driven by inflation. Inflation was tied to the cycle, and expectations of recession meant lower yields. in the long term. Now, 50 years later, things are very different. Many countries have inverted yield curves without having recessions,” concludes Paul Donovan, strategist at UBS.
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