Research Note | Is an inverted US yield curve a recession warning?

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    Is an inverted US yield curve a recession warning
    Is an inverted US yield curve a recession warning
    04 April 2022

    Key Highlights

    • The yield differential between US 2-year and 10-year Treasury yields has turned flat or negative
    • Investors are concerned that this signals an impending recession, as happened in the past
    • However, economic indicators are still important to watch, and these suggest a slowing but positive trend

    What happened to the yield curve last week?

    Bond markets are abuzz with speculation. A phenomenon that is relatively rare but psychologically important has become the focus for many investors, i.e. the on and off inversion of the yield curve.

    Over a volatile few days last week, the 10-year US Treasuries yield reached 2.54 per cent on Monday, its highest point of the week, and fell to 2.32 per cent on Thursday, its lowest point of the week. These levels were uncomfortably close to the 2-year Treasury yields, which ranged from 2.45 to 2.27 per cent over the week.

    And at times, 10-year yields were trading lower than 2-year yields. This is called an inverted yield curve and is seen by the market as a reliable indicator that a recession is on the cards for the US. This is because a yield curve inversion has occurred six out of the seven recessions seen in the US since 1978.

    Why is an inverted yield curve so ominous?

    In a standard period of good growth expectations, yields of longer-term bonds can be expected to be higher than those of shorter-term bonds. Investors holding longer-term bonds are taking more duration risk, so yields increase as durations extend.

    This is because the further out that you venture into the future, the greater the uncertainties about economic outcomes. Investors would expect to be rewarded for taking this additional risk and the long-term average spread between 2 and 10-year Treasuries is about 90 bps.

    However, there are times when this spread becomes tighter. This happens when the US Federal Reserve is expected to aggressively raise interest rates, thereby pushing up short-term yields. On the other hand, the demand for longer-term bonds is subdued given market concerns that higher rates will hurt the economy. As such, their yields fail to keep pace. In extreme cases, the yields of shorter-term bonds start to equal or overtake their longer-term counterparts, leading to a yield curve inversion.

    Self-fulfilling prophecy?

    The table below shows that since 1955, rate hikes are indeed eventually followed by a recession but this can take at least a year and is more commonly between two or three years.


    Figure 1: Recessions tend to start only several years after the start of rate rises

    Hikes begin Recession starts*
    Apr-55 28
    Sep-58 19
    Nov-67 25
    Mar-72 20
    Dec-76 37
    Aug-80 11
    May-83 86
    Dec-86 43
    Mar-88 28
    Feb-94 85
    Jun-99 21
    Jun-04 42
    Dec-16 38
    Median 28
    Trimmed Median 37

    Source: UOBAM/State Street
    *Number of months following the beginning of interest rates hikes


    Usually, central banks try to ease in their rate hikes gradually in order not to stall economic growth. The Russia-Ukraine war has not afforded the world this luxury. Instead, rising energy prices, sanctions, and other disruptions have pushed inflation to multi-year highs, forcing central banks like the Fed to signal a faster-than-usual schedule of hikes.

    However, it is worth understanding, for any sustained period of yield curve inversion, whether it is the upcoming recession that is causing the curve to invert, or whether in fact, it is the inverted yield curve that has to potential to cause a recession.

    Campbell Harvey, professor of finance at the Fuqua School of Business, Duke University, is a pioneer of the concept of yield curves as a predictor of recessions. He noted that this intense market focus could be a self-fulfilling prophecy, that is, people and businesses start to change their behaviours and spend or invest less, thereby precipitating rather than reacting to a recession.

    Bond vs equity markets

    It is the idea that an inverted yield curve is not a signal, but a reason, for slowing growth that could help explain the fact that equity markets are trending in the opposite direction to bond markets.

    Instead of the shape of the yield curve, equity investors are looking instead at indicators such as company earnings upgrades, employment data and the Purchasing Managers Index (PMI) to assess whether a recession is indeed imminent. These indicators appear to tell a different story. For example, although the first-quarter earnings season has not begun in earnest, last week seven S&P 500 companies reported 1Q earnings and five of them beat consensus EPS expectations.

    It is positive news like this that has helped calm US equity markets despite the ongoing Russia-Ukraine conflict, with the S&P500 now 5.2 per cent above where it was a month ago.

    Recession not our base case

    As multi-asset portfolio managers, UOBAM closely watches both bond and equity market signals. Despite the current flatness of the yield curve, we have not changed our base case that economies are set to expand moderately over the next few months.

    We would note that the yield spread between the 3-month and 18-month Treasuries, a measure that the Fed referenced recently, remains positive and fairly steep. However, we would expect this not to last, and for this curve to also invert over the next three months.

    However, once a yield curve flattens or invests, there is a tendency for bond yields to fall (i.e. bond prices to rise) since they are not able to move higher in a parallel manner. As such, we would expect yields of 10-year Treasuries to trade within a 2.0 to 2.25 per cent range over the next few months.


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