A major signal to the market faltered on Tuesday, pointing to recessionary periods.
The yield on two-year Treasuries has risen higher than the yield on 10-year Treasuries, a phenomenon known as an inverted yield curve.
The yield curve is a reliable indicator of recession, having reversed before each of the last eight recessions as measured by the National Bureau of Economic Research. Inverted yield curve in 2007, foreshadowing a 2008-09 recession. It also turned around in 2019 and the economy fell into a brief epidemiological lockdown that led to a recession the following year.
The yield curve inverted briefly in March and April and again in June.
The difference between the two-year and 10-year yields has been shrinking for weeks as investors reassessed their expectations for interest rates next year. Earlier, the federal money futures market reflected the view that the Federal Reserve’s target interest rate will continue to climb over the next year, eventually reaching around four percent.
Now these expectations have been turned upside down due to signs that economic growth in the US may be much weaker than expected. Bank of America analysts believe there is a 40 per cent chance of a recession next year. Others are questioning whether the US may already be in a recession after the economic downturn in the first three months of the year and looks set to enter its second consecutive quarter of negative growth.
Consumer spending shrank in May after adjusting for inflation, many measures of consumer confidence reached very low levels, and surveys by the Institute of Supply Management and several regional federal banks showed a manufacturing contraction. Construction spending declined in May and spending on single-family home construction was flat during the month. However, factory orders were stronger than expected and unemployment remains very low.
The market now appears to be signaling that investors believe the Fed will have to stop raising interest rates or even cut its target next year to stave off an even worse deterioration. Some believe that the economic downturn will be strong enough to eliminate inflation, especially if it causes the unemployment rate to rise sharply. Others fear that we might get slow or negative growth, high unemployment, and high inflation.
Economists argue exactly why an inverted yield curve reliably predicts a recession. The 2019 reversal was clearly not due to investors anticipating the pandemic, although the pandemic and government assistance to support the economy may have essentially covered the recession that would have occurred anyway. Some analysts believe the reversal could trigger a mechanical recession, possibly by reducing banks’ willingness to lend. Others say the inversion only reflects more murky information indicating that a recession is in the future.
When the yield curve inverted in 2019, there were many who claimed that “different this time. This is not the case today simply because many believe the risks of a recession are high. Some believe that the yield curve signal has been distorted by the Fed’s expanded balance sheet and possibly by the economic turmoil triggered by the pandemic. There is also a question as to whether the yield curve signal might be. Mix it up with the fact that Treasury bonds of all maturities now have negative yields, which means that they will lose money if inflation remains at the current level or even at the expected low levels over the next several years.
Some economists insist that it is not the difference between 10-year and 2-month returns that matters but the difference between 10-year and three-month returns. With a three-month yield of 1.713, this part of the curve remains uninverted.
There have been false alarm reversals in the past. The curve reversed in 1966 and briefly in 1998 without leading to a subsequent recession. Some might take the 2019 reversal as a false alarm, too — although we can’t tell if we’d have experienced a recession without the pandemic.
Stocks tend to do well in the months following a reversal. Energy stocks, in particular, appear to be doing well in the wake of the coup, according to research from Bank of America. In fact, energy stocks have been among the best performing stocks since the conversion in March.