Wall Street’s most talked-about recession indicator has issued the biggest warning in 20 years, raising investor concerns that the US economy is heading for a slowdown.
This indicator, called the yield curve, is a way of showing how interest rates on various US Treasuries are compared., Especially 3 month invoices, and 2 and 10 year Treasury notes.
Fixed income investors usually expect to receive more payments by fixing their funds over the long term, so the interest rate on short-term bonds is lower than the interest rate on long-term bonds. The various yields of bonds plotted on the chart create an upwardly sloping line, or curve.
However, sometimes short-term interest rates exceed long-term interest rates. The negative relationship distorts the so-called reversal curve, indicating that the normal situation in the world’s largest government bond market has reversed.
It is considered a precursor to economic collapse, as a reversal has occurred over the last half century prior to all US recessions. And that’s happening now.
The yield curve has predictive power not found in other markets.
The yield on 2-year government bonds on Wednesday was 3.23%, which is higher than the 10-year bond of 3.03%. Compared to a year ago, the two-year yield was more than one percentage point lower than the ten-year yield.
The Fed’s belief in inflation at the time meant that inflation was temporary and the central bank was unaware of the need to raise interest rates rapidly. As a result, yields on short-term government bonds remained low.
But over the past nine months, the Fed has begun to tackle sharp inflation by raising interest rates rapidly, raising concerns that inflation will not slow down naturally. By next week, when the Fed is expected to raise interest rates again, its policy rate has risen about 2.5 percentage points from near zero in March, pushing up yields on short-term government bonds such as two-year bonds.
Investors, on the other hand, are becoming more and more afraid that central banks will go too far and slow down the economy enough to cause a serious recession. This concern is reflected in the long-term Treasury yield decline, such as 10 years, which tells us more about investors’ expectations for growth.
Stock market conditions
The decline in the stock market this year was painful. And it is still difficult to predict what lies ahead for the future.
Such tensions are reflected in other markets as well. US stocks have fallen nearly 17% so far this year as investors reassessed the company’s ability to withstand the slowdown in the economy. Copper prices have fallen by more than 25% worldwide as they are used in array consumer and industrial products. And the US dollar, a paradise for times of concern, is the strongest in 20 years.
It’s that predictive power that sets the yield curve apart, and the recession signals we’re currently sending are more than they were in late 2000, when the tech bubble began to burst and the recession was just a few months away. It’s powerful.
The recession occurred in March 2001 and lasted for about eight months. By the time it began, the yield curve had already returned to normal as policymakers began to cut interest rates in an attempt to restore the economy to a healthy state.
The yield curve is also The global financial crisis that began in December 2007Initially, it reverses in late 2005 and remains in that state until mid-2007.
That track record is why investors across financial markets are paying attention as the yield curve reverses again.
“The yield curve isn’t the gospel, but I think it ignores your own risk,” said Greg Peters, co-chief investment officer of asset management firm PGIM Bonds.
But which part of the yield curve is important?
On Wall Street, the most commonly referenced part of the yield curve is the relationship between 2-year and 10-year yields, but some economists instead have 3-month invoice yields and 10-year notes. I like to focus on the relationship.
The group includes one of the pioneers in research on the predictive power of yield curves.
Campbell Harvey, now a professor of economics at Duke University, developed a model that could predict U.S. growth during a summer internship at the now-closed Canadian mining company Falconbridge in 1982. I remember being asked.
Harvey turned to the yield curve, but the United States had already been in recession for about a year and was quickly fired due to economic conditions.
He received his PhD until the mid-1980s. He is a candidate for the University of Chicago and has completed his work showing that yields of three months and ten years have reversed prior to the recession that began in 1969, 1973, 1980, and 1981.
Harvey said he preferred to consider a three-month yield because it’s close to the current situation, but others have more direct expectations of investors for immediate changes in the Fed’s policies. He said he was catching.
For most market watchers, the different methods of measuring the yield curve all point broadly in the same direction, indicating a slowdown in economic growth. “These are’different flavors’, but they’re all ice cream,” said Bill O’Donnell, interest rate strategist at Citibank.
The 3-month yield is below the 10-year yield. Therefore, this measure does not reverse the yield curve, but the gap between the yield curves is closing rapidly due to growing concerns about deceleration. By Wednesday, the difference between the two yields had dropped from more than 2 percent points in May to about 0.5 percentage points. This is the lowest since the 2020 pandemic recession.
The yield curve can’t tell us everything.
Some analysts and investors claim that the yield curve as a popular recession signal is over-focused.
One of the common criticisms is that the yield curve tells us very little about when a recession will begin. According to Deutsche Bank data, the average time to recession after a two-year yield exceeds a ten-year yield is 19 months. However, the range is 6 months to 4 years.
The economy and financial markets have also evolved since the 2008 financial crisis, when the model last became popular. The Fed’s balance sheet has swelled as the Fed repeatedly purchased government and mortgage bonds to support financial markets, and some analysts argue that these purchases could distort the yield curve. ..
Both of these are points that Harvey accepts. The yield curve is an easy way to predict the growth trajectory and potential recession of the United States. Proven to be reliable, but not perfect.
He suggests using it in combination with research Chief Financial Officer’s Financial ExpectationsThey usually lower corporate spending as they become more worried about the economy.
He also pointed out the cost of borrowing a company as an indicator of the risks investors perceive in lending to private companies. These costs tend to rise as the economy slows. Both of these measures are currently talking about the same thing. Risks are rising and expectations for a slowdown are rising.
“If I go back to my summer internship, should I just look at the yield curve? No,” Harvey said.
But that also does not mean that it is no longer a useful indicator.
“It’s useful. It’s very valuable,” Harvey said. “It’s a duty for managers of every company to take the yield curve as a negative signal and engage in risk management, and for people too. Now, when it comes to getting the most out of your credit card on a high vacation. There is none.”