David Dee Delgado | Getty Images News | fake images
The bond market is showing a warning sign for the US economy.
That omen is called an “inverted yield curve.” These bond market investments have been reliable predictors of past recessions. Part of the yield curve invested on monday.
However, an economic recession is not assured. Some economists think the warning is a false alarm.
This is what you should know.
An inversion in the yield curve does not trigger a recession. Instead, it suggests that bond investors are worried about the economy’s long-term prospects, Roth said.
“It doesn’t mean a recession is coming,” Roth said of the investments. “It just reflects concerns about the future economy.”
The 2-year and 10-year Treasury yield curves inverted before the last seven recessions since 1970, according to Roth.
However, the data suggests that a recession is unlikely to be imminent if it materializes. On average, it took 17 months after the bond market inverted for a recession to start. (Roth’s analysis treats the double dip recession in the 1980s as a recession.)
There was a false alarm in 1998, he said. There was also an inversion just before the Covid-19 pandemic, but Roth said that can also possibly be considered a false alarm, as bond investors could not have predicted such a health crisis.
“It doesn’t work all the time, but it has a high success rate in foreshadowing a future recession,” said Brian Luke, head of Americas fixed income at S&P Dow Jones Indices.
The Federal Reserve, the US central bank, has a huge influence on bond yields.
Fed policy (that is, its benchmark interest rate) generally has a greater direct impact on short-dated bond yields relative to those on longer-dated bonds, Luke said.
Long-term bonds don’t necessarily move along with the Fed’s benchmark (called the fed funds rate). Instead, investors’ expectations about future Fed policy have more influence on long-dated bonds, Luke said.
That has helped boost short-term bond yields. Long-term bond yields have also risen, but not by as large a margin.
The 10-year Treasury yield was about 0.13% higher than that of the 2-year bond through Monday. The spread was much higher (0.8%) in early 2022.
Investors seem worried about the so-called “hard landing”, according to market experts. This would happen if the Fed raises interest rates too aggressively to control inflation and accidentally triggers a recession.
During recessions, the Federal Reserve lowers its benchmark interest rate to stimulate economic growth. (Lowering rates lowers borrowing costs for individuals and businesses, while raising them has the opposite effect.)
Therefore, an inverted yield curve suggests that investors see a recession in the future and are therefore pricing in the expectation of a long-term Federal Reserve rate cut.
“It’s the bond market trying to understand the future path of interest rates,” said Preston Caldwell, head of US economics at Morningstar.
Treasury bonds are considered a safe asset since the US is unlikely to default on its debt. Investors’ flight to the safety of (and thus higher demand for) long-dated bonds also serves to suppress their yield, Luke said.
A recession is not a foregone conclusion.
The Federal Reserve may well calibrate its interest rate policy and achieve its goal of a “soft landing,” whereby it reduces inflation and does not cause an economic contraction. The war in Ukraine has complicated the picture, fueling a rise in the prices of raw materials such as oil and food.
“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 on.”
However, many economists have adjusted their economic forecasts. JP Morgan puts the odds of a recession at about 30% to 35%, above the historical average of about 15%, Roth said.