Recession warning sign flashes as yield curve inverts

The market’s most-watched part of the yield curve inverted on Friday, and if its record high over the past half-century is any indicator, the US could be headed for a recession soon.

But others say the Fed’s unprecedented shootout with high inflation makes this yield curve inversion different from those of decades past.

On Friday, the 10-year US Treasury yield ended the day at 2.38%, 6 basis points below the 2-year US Treasury yield of 2.44%.

This phenomenon has a strong track record of predicting a recession; each of the last eight recessions (going back to 1969) was preceded by the 10-year bond yield falling below the 2-year bond.

Although other live measures showed reversals occurring briefly intraday on March 29 and again on March 31, the US Treasury did not recognize a reversal (such as recorded at closing market bid prices) until Friday afternoon.

The yield curve maps U.S. Treasuries of various durations and typically shows longer-dated Treasuries (such as those with 10- or 30-year maturities) that have higher yields than Treasury bonds. Treasury with shorter dates (ie 3-month or 2-year maturities). .

[Read: Bonds, yields, and why it matters when the yield curve inverts — Yahoo U]

The curve “inverts” when shorter-dated Treasury yields exceed longer-dated Treasury yields. Curve points have already inverted in recent weeks (3-year and 5-year on March 18, 5-year and 30-year on March 28).

But 2-year and 10-year points are often sought after because they are among the most commonly traded durations. An inversion at these particular points has correctly forecast a recession eight months to two years in advance in each of the last eight recessions.

Is the recession coming?

However, there is nothing in the price of bonds that directly triggers a recession. For example, the first recession warning before the 2020 recession came in the form of yield curve inversion in August 2019. But the financial markets could not have known that a global pandemic would be the reason for that recession.

And despite investing’s strong track record in predicting recessions, some strategists have warned that more context needed when looking at this year’s investment between yields at 2 and 10 years.

In the face of rapid inflation, the Federal Reserve is in the process of raising interest rates at their fastest pace since 1994. Bond markets have had to quickly reprice through this policy pivot, meaning investments they could be a temporary side effect of the Fed’s actions. (rather than a more fundamental market concern about duration risk).

Mark Haefele, chief investment officer at UBS Global Wealth Management, wrote this week that the Fed’s direct ownership of US Treasuries may also be a factor in the shape of the curve.

“While this intervention is difficult to separate from other variables, it is possible that such quantitative easing has made yield curve inversions more likely, reducing their predictive power,” he noted on March 29.

Still, economists say the risk of a Fed-induced recession is real as policymakers raise borrowing costs. The challenge: avoid a “hard landing” in which tighter policy abruptly ends the recovery, raises unemployment and dampens growth.

“The warning sign is the comment that the Fed could raise rates six more times this year in the context of a US economy that is still very dovish,” Stifel chief economist Lindsey Piegza told Yahoo Finance on 1 of April.

Savita Subramanian, head of US equity and quantitative strategy at BofA Securities, warns that the overall curve story cannot be dismissed with “technical” explanations such as the Fed’s asset purchases.

“That’s in line with the arguments we’ve heard in recent cycles of ‘this is technical, it doesn’t matter, it doesn’t mean the same thing about growth,'” Subramanian told Yahoo Finance on April 1. I think it could, I think the yield curve has been a reliable indicator and I wouldn’t rule it out.”

Brian Cheung is a reporter who covers the Fed, the economy, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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