Bonds flash recession warning light as a key part of the yield curve inverts again

The bond market is warning that the economy could fall or is already in recession, according to a closely watched metric.

Market professionals observe the spread on the government bond yield curve, or the difference between longer-duration government bond yields and shorter-duration government bond yields. Typically, longer-duration yields, such as the 10-year note yield, are higher than shorter-duration yields, such as the 2-year yield. But the 2-year yield has now risen above the 10-year yield.

As of Tuesday afternoon, the 2-year Treasury yield was 2.792%, ahead of the 10-year’s 2.789% rate. You can monitor this key distribution in real time here.

This so-called inversion is a warning sign that the economy could be weakening and a recession is possible.

“There’s something afoot in investor sentiment that’s hard to ignore as the inversion happens at 10-year yields below 3%,” said Ian Lyngen, head of US rates strategy at BMO. “I wouldn’t say that’s a direct indication that a recession is a near-term risk. Rather, it is consistent with rising concerns about a recession.”

One way to look at the importance of the yield curve is to think about what it means for a bank. The yield curve measures the spread between a bank’s cost of money and what it will earn by lending or investing it over a period of time. When banks can’t make money, lending slows and with it economic activity.

After rising to nearly 3.5% in mid-June, the 10-year yield has fallen to 2.78%, hovering just below the 2-year yield of 2.79%. The 10-year stock had risen higher on inflation concerns but reversed course as investors grew more concerned about the economy. Yields move inversely to bond prices.

The 10-year benchmark is widely watched as it affects mortgage and other lending rates. The 2-year note is much more affected by Federal Reserve rate hikes and is moving higher.

“I don’t know in and of itself that this is a recession indicator,” said Gregory Faranello, chief of US interest rates at AmeriVet Securities. “For the Fed, a battle rages between inflation and growth. In my view, inflation still comes before growth.”

The 2-year to 10-year curve first inverted on March 31, then briefly again in June. Faranello also pointed out that the curve was inverted in 2019 and warned of a recession. However, since the Federal Reserve was cutting interest rates at the time, a 2020 recession may not have happened without the pandemic.

Certainly, some investors and economists typically want the inversion to last for an extended period of time before believing it is forecasting a recession.

In recent weeks, the market has been scared by the potential for a recession. Economic data has weakened and Federal Reserve Chair Jerome Powell has indicated that the central bank would remain steadfast in its fight against inflation. Investors are increasingly concerned that the Fed will hike interest rates enough to slow the economy to the point of tipping it into recession.

While the market has grown fearful, many Wall Street economists do not expect a recession this year, although some predict the economy could enter a period of contraction next year.

Faranello said Powell was recently asked about the potential for a yield curve inversion. “His reply was, ‘We’re not worried about that right now. We’re worried about bringing inflation down to 2%.’ Inflation is definitely more important than growth and the Fed isn’t worried about an inverted yield curve,” Faranello said.

Aside from weaker data, investors are focused on the Atlanta Fed’s GDPNow indicator, which forecasts gross domestic product shrank 2.1% in the second quarter. The forecast is based on incoming data. If the second quarter shrinks, it would be the second consecutive negative quarter technically considered a recession.

“It gets more and more believable the closer it gets to actual printing because it’s cumulative,” Lyngen said. Growth slowed by 1.6% in the first quarter.

According to Bespoke, if the yield curve inverts, “there was a more than two-thirds chance of a recession sometime in the next year and a more than 98% chance of a recession sometime in the next two years.”

https://www.cnbc.com/2022/07/05/bonds-flash-recession-warning-light-as-key-part-of-the-yield-curve-inverts-again.html Bonds flash recession warning light as a key part of the yield curve inverts again

Joshua Buckhalter

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