September 30, 2022

The bond market is issuing a warning that the economy may be declining or has already entered a recession, according to one closely watched metric.

Market professionals watch the spread on the Treasury yield curve, or the difference between the yields of longer-dated Treasury securities and those of shorter duration. The yield of a longer term, such as the yield on a 10-year bond, is usually higher than the yield of a shorter term, such as that of a two-year bond. But the two-year yield is now above the 10-year yield.

As of midday Tuesday, the two-year Treasury yield was at 2.792%, above the 2.789% 10-year rate. You can monitor the spread of this key in real time here.

This so-called reversal is a warning sign that the economy may weaken and a recession is possible.

“Something is afoot in investor sentiment that is hard to ignore, given that the reversal is happening with 10-year yields of less than 3%,” said Ian Lingen, head of US interest rate strategy at BMO. “I wouldn’t say it’s a direct indication that a recession is a near-term risk. Rather, it is consistent with growing concern about a recession.”

One way to look at the significance of the yield curve is to think about what it means for the bank. The yield curve measures the difference between the cost of a bank’s money versus what it would earn by lending or investing it over a longer period of time. If banks can’t make money, lending slows and so does economic activity.

After a rally to nearly 3.5% in mid-June, the 10-year yield fell to 2.78%, hovering just below the 2-year bond yield of 2.79%. The 10 years moved higher on inflation concerns, but reversed course as investors became more concerned about the economy. Yields move opposite bond prices.

The 10-year index is widely watched as it affects mortgages and other lending rates. The two years are affected much more by the rate hike by the Federal Reserve, and it is moving higher.

“I don’t know by itself that it’s a recession indicator,” said Gregory Varanello, head of US interest rates at AmeriVet Securities. “There is an ongoing battle between inflation and growth for the Fed. My view is still inflation is above growth.”

The 2- to 10-year curve inverted first on March 31, and then again briefly in June. Varanello also noted that the curve reversed in 2019, warning of a recession. But since the Fed was cutting rates at the time, he said a recession might not have happened in 2020, had it not been for the pandemic.

To be sure, some investors and economists usually like to see a reversal last for an extended period of time before believing that a recession is expected.

In the past several weeks, the market has grown even more freaked out by the prospect of a recession. Economic data weakened, and Federal Reserve Chairman Jerome Powell indicated that the central bank will be steadfast in its battle with inflation. Investors are becoming more concerned that the Federal Reserve will raise interest rates to the point that it is slowing the economy to the point where it is heading into a recession.

While the market is getting scared, many Wall Street economists don’t expect a recession this year although some predict that the economy may enter a period of deflation next year.

Faranello said Powell was recently asked about the potential for yield curve inversion. His answer was: “We’re not worried about that now. We’re worried about bringing inflation down to 2%.” “It’s definitely inflation above growth, and the Fed is not worried about an inverted yield curve,” Varanello said.

Besides watching the weaker data, investors are focusing on Atlanta Federal Reserve GDP indicator, which expects second-quarter gross domestic product to contract 2.1%. Forecasting is based on incoming data. If the second quarter contracts, it will be a negative second quarter in a row, which is technically a recession.

“Its credibility increases the closer you get to the actual publications because they are cumulative,” Lingen said. Growth in the first quarter contracted by 1.6%.

According to Bespoke, when the yield curve is inverted “there was a better than two-thirds chance of stagnation at some point next year and a greater than 98% chance of stagnation at some point within the next two years.”

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