In recent weeks, various yield curves have inverted, and the attention jumped each time as if a “self-destruct” button was pushed. We appreciate the yield curve for what it is - a true long-term leading indicator of recession - but can't take calls for a US economic contraction seriously before 2023.
As expected, recent media coverage is also all about the story of yield curve inversion and recession just as they were the last time the curve inverted in 2018. (Did the yield curve predict the recession or did it predict COVID in 2020?) First, it was the US Treasury 5-year note above the 10. Now, it’s 2s above 10s. Yet 20s and 30s are above 2s - So which one matters?
The chart below contrasts the 10s/Fed funds curve with the 10s/2s curve and is important for our understanding. The key question is whether the US Federal Reserve will actually follow through on all the tightening that is expected. It’s the Fed pushing risk free cash yields above the (risky) returns of other investments that contributes to eventual contraction in the economy.
When idle cash positions produce the highest risk-adjusted return, the incentive to invest declines. The longer the Fed persists at this, the greater the impact. Financial markets are faster than the real economy in making adjustments, hence financial markets give us lead time before recession in the real economy.
The fact that the 10s/2s yield curve is historically a good long-term leading indicator of recession (like 10s/3s, 20s/5s, etc.) is because of the general correlation of yields. The 2-year US Treasury by itself is not an important benchmark for borrowing or lending in the US economy. Yet it normally isn’t priced 2 percentage points above the Fed’s key policy rate.
FIGURE 1: US TREASURY 10-YEAR YIELD LESS FED POLICY RATE AND 10-YEAR LESS 2-YEAR
Source: Bloomberg and Haver Analytics as of April 1, 2022.
We want to take the yield curve seriously for what it is, a true long-term leading indicator of recession (See our recent CIO Bulletin, “Three Scenarios for the Economy and Markets”). With the long lead time it provides, we wouldn’t take contraction calls for the US economy seriously before 2023.
For financial markets, however, that’s this year’s business. Still, the stark gap between the two yield curves below shows the Fed still has the choice to follow through with what is now priced: 1) near record increases in the federal funds rate in a single year, 2) Quantitative Tightening (only the second time in modern history), and 3) tightening during a fiscal contraction.
The Fed has a choice akin to Charles Dickens’ Scrooge learning from Ghost of Christmas Future. There’s still time to take a different path.