Few statements frighten the hearts and minds of investors as much as those ominous three words: “yield curve inversion”. When yields on bonds with longer maturities fall below those with shorter time horizons, there is a reasonable chance that a recession is on its way – at least according to data going back decades. As always, however, there are caveats to the “inversion therefore recession” logic. False positives have occurred, most recently when the 10-year and 2-year Treasuries reversed briefly in September 2019. This short-lived reversal was actually followed by a recession in March 2020, but that recession was a deliberate decision to shut down the entire economy based on an event no one knew about in September 2019.
And you, six-month bill?
False positives aside, the current shape of the yield curve really gives the impression that the bond market is expecting a recession in the not too distant future. Not only 2-year treasuries, but also 1-year and even 6-month treasuries are now being reversed into 10-year notes. The 6-month was at par with the 10-year based on yesterday’s close (see chart below), but as of early morning today, the 6-month yield is 2.86% versus 2 .77% for 10 years.
Interestingly, the longer-term maturity compression had a mostly positive effect on the stock market this week, particularly in the growth-oriented segments of the market that benefit more from lower interest rates. The 10-year Treasury is widely used as a benchmark for calculating a company’s cost of capital. So, when this rate drops, the value of the company increases. In recent weeks, growth stocks, which bore the brunt of the stock market pullback earlier this year, have outperformed their value stock counterparts by a substantial margin.
It’s worse elsewhere
Part of the explanation for the inverted curve, however, may have nothing to do with recession potential and a lot to do with things in other parts of the world being worse than they look. are here with us. The US dollar has appreciated strongly against other major currencies, including the euro, the pound sterling and the Japanese yen, sometimes reaching levels not seen for more than 20 years. A stronger dollar increases the attractiveness of US assets. Medium and long-term Treasury securities form a core portfolio for central banks and foreign financial institutions.
In fact, one of those “false positive” moments for inverted yield curves happened during another monetary tightening from the Fed. In 2006, then-Fed Chairman Ben Bernanke expressed bewilderment as to why the 10-year yield was lower than that of shorter maturities. The chart below is a replica of the one above for the period January to December 2006, and you can see that the reversal lasted most of the second half of this year.
The answer to Bernanke’s bewilderment turned out to be a massive demand for intermediate and long US Treasuries by foreign institutions, especially China’s central bank for foreign exchange reserve purposes. Today, with China seemingly in perpetual lockdown, Europe grappling with a plate full of social, political and economic crises and the threats of more defaults in emerging markets like the Sri Lanka, the case for US Treasuries also looks strong.
Maybe yes, maybe sweet?
The likelihood of some sort of recession over the next six months is almost certainly north of zero and possibly well north. But there’s almost nothing in the current batch of macro data to suggest that if one were to happen, it would be of a heartbreaking variety like 1980 or 2008. A more likely comparison would be 2001, when the economy was technically in a recession for eight months but has never even seen two consecutive quarters of negative growth. A mild recession could well be the price to pay for lowering inflation. It would be better, for example, to avoid recession altogether but live with an extended period of slow growth and high inflation similar to the 1970s.
And perhaps that result is, in fact, what the bond market is signaling. Credit risk spreads between Treasuries and lower-quality corporate securities have increased slightly in recent weeks, but are still below their three-year averages, suggesting that fears of an impending wave of business failures are not present. We’ll see more pieces of the puzzle come together in the coming weeks with the release of Q2 GDP and the bulk of earnings reports from the major constituents of the S&P 500. For now, however, the odd shape of the yield curve does not tell us to run for the hills.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.