America’s recession alarm has sounded. The most watched part of the US yield curve – which plots the yields on different maturities of US government bonds – has briefly inverted for the first time since 2019.
In normal conditions, investors holding longer-duration bonds will demand higher yields than those holding shorter ones. But if markets think that interest rates in the future will be lower than they are now – eg, because a recession forces interest rate cuts – then the usual pattern can invert.
On Tuesday, yields on the two-year US Treasury note rose as high as 2.45%, a fraction above the 2.38% yield on the ten-year bond. Other parts of the curve, including the five-year to 30-year and the five-year to ten-year spreads, had already inverted, but the two-year to ten-year spread is the most closely watched. Previous inversions have predicted every US recession since the 1970s (although the curve has also sounded a few false alarms). The recessions usually follow between six to 24 months after the yield curve first inverts.
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This time really could be different
Yield-curve inversion might not be what it was. Some argue that the 2019 inversion, which heralded the Covid-19 recession the following year, was a fluke. Markets don’t possess magical epidemiological foresight. Certainly, central-bank quantitative easing (QE) programmes have distorted the bond market in recent years, says Shuli Ren on Bloomberg. “The yield curve is getting flatter by design”.
The US Federal Reserve has begun to raise interest rates, with markets expecting a cumulative 2% hike by the end of the year. That raises the yield on short-term government debt (such as the two-year Treasury note). At the same time, “until early March the central bank was still buying longer-dated Treasuries”, which depresses their yields. Financiers are used to taking an inverted yield curve as a “signal of impending doom”, but it may just be that central bank meddling “has broken the most reliable barometer of recession risks”.
“The yield curve’s recession signal is distorted,” agrees Michael Contopoulos of Richard Bernstein Advisors. Take away the US central bank’s “massive purchases” of government bonds and the “ten-year yield would be closer to 3.70%”, considerably higher than the current two-year yield and far off inverted. As the Fed unwinds QE, there is scope for longer-dated yields to rise.
The end of negative yields
Regardless of the shape of the curve, government bond yields have been climbing (and prices falling) across the board. “The Bloomberg Global Aggregate bond market index has lost over 11% since its peak in January 2021,” says Robin Wigglesworth in the Financial Times. The index has “lost $2.4trn in value so far in 2022”, reckons Matthew Hornbach of Morgan Stanley. As it does so, debt that yields less than 0% is also becoming rarer. In 2020 there were $18trn in “sub-zero” bonds globally (ie, investors effectively paid some governments and firms to borrow). As yields have risen, that figure is down to $2.9trn today. The yield curve may be giving unclear signals, but another bond-market distortion is more visibly unwinding.
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