Quick takes on capital markets

11 Feb 2022

Treasury yield curve: Signaling r-r-r-recession?

An inverted yield curve is a recessionary signal. Yet, despite recent curve flattening as markets price in a steep Fed hiking cycle, strong consumer spending power, cash-rich balance sheets, and modestly tight credit spreads point to investor fears of a looming recession being overblown.

Yield curve steepness
10-year minus 2-year yields, recessions are shaded, 1975 – present

Stock market pullbacks chart
Source: Clearnomics, Federal Reserve, Principal Global Investors. Data as of February 9, 2022.

The U.S. Treasury yield curve has inverted ahead of every U.S. recession since the 1950s. In recent months, the curve has flattened, significantly, prompting some investors to whisper the "R" word.

The 2s10s Treasury yield curve (the difference between the yields on 2-year and 10-year U.S. government debt) has flattened from a peak of 158 basis points (bps) in late Q1 2021 to under 50bps today. In previous Federal Reserve (Fed) hiking cycles, the spread has narrowed by around 80bps in the first year of tightening. On that basis, the curve could invert within the year. However, there are three important considerations:

  1. The huge quantities of government bonds owned by central banks are suppressing long-term yields. Given the lower starting point, it may be easier for the curve to invert, thus fading the recessionary signal.
  2. Markets have already priced in significant Fed tightening for 2022, so some of the "first-year flattening" has likely already occurred.
  3. The lead time between curve inversion and recession tends to be long and variable, on average 12-18 months, but sometimes extending to four years.

Other factors paint a more reassuring picture. Consumers have a huge excess savings cushion, corporate balance sheets are cash-rich, and credit spreads—another recessionary signal—continue to be relatively tight. It's far too early to start uttering the "R" word.

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