Stock market investors should watch this part of the yield curve for the “best leading indicator of trouble ahead.”

Investors have been watching the US Treasury. yield curve for investments, a reliable predictor of past economic downturns.

They don’t always agree what part of the curve although it is best to look.

“Yield curve inversion and flattening has been at the forefront for everyone,” Pete Duffy, chief investment officer at Penn Capital Management Company, in Philadelphia, said by phone.

“That’s because the Fed is very active and rates suddenly went up very fast.”

A yield curve inversion occurs when rates on longer-dated bonds fall below those on shorter-dated debt, a sign that investors believe economic trouble could emerge. Fears of an economic slowdown have been rising as the Federal Reserve begins to tighten financial conditions, while Russia’s invasion of Ukraine threatens to keep key drivers of US inflation high.

Lately, the focus has been on the 10-year Treasury yield TMUBMUSD10Y,
2.488%
and a shorter 2-year yield, where the spread fell at 13 basis points on Tuesdayup from a high of about 130 basis points five months ago.

Read: The Yield Curve Is Accelerating Towards Investing: Here’s What Investors Need To Know

But that’s not the only plotline on the Treasury yield curve that investors are watching closely. The Treasury Department sells securities that mature in a range from a few days to 30 yearsproviding a lot of plots on the curve to follow.

“The focus has been on the 10s and the 2s,” said Mark Heppenstall, chief investment officer at Penn Mutual Asset Management, in Horsham, Penn, a suburb north of Philadelphia.

“I will hold out until the bills for 10 to 3 months are reversed before I get too negative on the economic outlook,” he said, calling it “the best indicator of trouble ahead.”

See 10 years, 3 months

Instead of falling, that extended climbed in March, continuing its upward path since turning negative two years ago at the start of the pandemic (see chart).

The yield spread from 3 months to 10 years is increasing

Bloomberg data, Goelzer investment management

“The 3-month Treasury bill really tracks the Fed’s target rate,” Gavin Stephens, director of portfolio management at Goelzer Investment Management in Indiana, said by phone.

“Then it gives you a more immediate picture of whether the Fed has entered a tight state in terms of monetary policy and therefore gives you the possibility that economic growth will contract, which would be bad for stocks.”

Stocks were lower on Friday, but with the S&P 500 SPX index,
-0.13%
and the Nasdaq COMP Composite Index,
-0.87%
still up 1.2% on the week. All three major indices are down between 4.5% and 10.1% so far in 2022, according to FactSet.

Seeing the 10 and the 2 TMUBMUSD02Y,
2,301%
spread, “You’re looking at expectations of where the Federal Reserve’s interest rate policy will be over a two-year period,” Stephens said. “So, effectively, it’s running on a lag.”

On average, from the time the 10 and 2 curve inverts, until “there’s a recession, it’s almost two years,” he said, predicting that with unemployment was recently pegged at around 3.8% that “this curve is going to invert when the economy is really strong.”

The Federal Reserve Bank of San Francisco also called the 3-month TMUBMUSD03M,
0.545%
and the 10-year curve ratio is his “preferred spread measure because it has the strongest predictive power for future downturns,” as in 2019, when the yield curve showed recession warning signs more regularly.

“Did you see COVID coming?” Duffy said, about past inversions on the yield curve.

A more likely catalyst was that investors were already on recession alert, with the US economy in its longest expansion period on record.

“There are several of these curves that you have to look at in their entirety,” Duffy said. “We’ve always said look at a lot of signs.”

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