Notoriety surrounding the Treasury yield curve is reaching new heights as investors ponder the potential consequences of the recent curve inversion. An inversion, also labeled negative term spread, occurs when long-term Treasury yields trade below the level of short-term rates. Negative term spread signals growing investor pessimism regarding the economic outlook and mounting risk of deflation.
When most economists failed to heed warning signs of a curve inversion before the Great Recession, economics’ reputation as “the dismal science” grew even more dismal. How could economists get it so wrong? Research published a decade earlier by the Federal Reserve Bank of New York found that yield curve inversion “
The forecasting track record for curve inversions has been nearly perfect during the post-World War II era, predicting all nine recessions since 1955 with just
The current curve inversion first appeared in late March, two months after the Federal Reserve officially communicated the end of its three-year tightening cycle. Bond market reaction to the Fed’s pivot was fast and furious, with Treasury yields falling across all maturities. Unlike previous inversions marked by “
Consumer borrowing rates are lower, in line with Treasury yields, and are already serving as a form of accommodation in anticipation of interest rate cuts later this year. With over $9 trillion in mortgage debt outstanding representing two-thirds of all household borrowing, the 1% decline in mortgage rates since November is significant for U.S. consumers. Lower rates will boost both new and existing home sales and refinancing activity.
The Fed’s policy U-turn in January also had a favorable impact on another widely followed recession indicator: corporate bond spreads. Following a challenging fourth quarter in 2018, corporate bond valuations rebounded sharply this year with both investment-grade and high-yield bonds registering nearly double-digit returns. Despite the yield curve slope beginning to flash red, other bond market indicators are painting a more optimistic picture for the U.S. economy.
The slope of the yield curve can do more than simply convey investor expectations for growth and inflation; it can also directly influence financial conditions. Credit availability typically tightens as the yield curve flattens and bank lending becomes less profitable. However, results from the just-released Fed large-bank stress testing found that banks are well capitalized and positioned “
The final factor adding complexity to the meaning of today’s curve inversion is the ever-growing volume of sovereign debt trading with negative yields. Long-term Treasury yields are most exposed to the gravitational pull from nearly $13 trillion in negative-yielding bonds, while short-term rates remain anchored to Fed policy. With an increasingly interconnected world due to the long-term trend toward globalization, Treasury yields today reflect not just the outlook for the U.S. economy, but for economies everywhere.
As philosopher George Santayana once said, “Those who do not remember the past are condemned to repeat it.” While this is certainly a wise expression, the yield curve inversion’s forecasting track record may not be the best indicator for predicting a recession in today’s complex market environment. Market participants should look to historical market and economic activity for guidance, but also keep a close eye on other factors influencing the curve inversion that indicate a less negative outlook for the U.S. economy in the near term.
