NEW YORK ( Associated Press) — One of the more reliable warning signs for an economic downturn began to shine again.
The “yield curve” is looked to for clues on how the bond market feels about the long-term outlook for the US economy. On Tuesday, the closely followed portion of the yield curve was briefly illuminated for the second time this year.
What is the yield curve?
At the heart of the investment world are the Treasury, the IOUs the US government gives to investors who lend money to it. The yield curve is a chart that shows how much different Treasuries are paying in interest.
At one end are short-term treasuries, which are repaid over a period of months or years. At the other end of the chart are longer-term Treasuries, which take 10 years or even decades to mature. Short-term yields closely follow those expectations for what the Federal Reserve will do with interest rates overnight, while long-term yields run more on expectations of future economic growth and inflation.
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Typically, longer-term Treasuries offer higher yields than shorter-term ones, resulting in an upward-sloping line chart. This is partly because investors typically demand higher yields to hold their money off longer, given the potential for future rate hikes by the Fed and the risk of inflation. But when investors worry about a sharp recession, perhaps because the Fed is raising short-term rates too quickly, they are less willing to accept Treasuries maturing several years into the future.
When the yield for short-term Treasuries exceeds the yield for the long-term, market watchers refer to this as an “inverted yield curve.” And when that chart has a downward sloping line, Wall Street starts to panic.
It’s hard to digest all the talk about charts and yields. The inverse of the yield curve is considered a reliable predictor of bearishness, although sometimes they reverse without being bearish.
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Some market observers, including Federal Reserve officials, consider the relationship between 3-month and 10-year Treasuries to be more significant. Every recession in the past 60 years has been preceded by an inversion of the yield curve between three-month and 10-year Treasuries.
There is usually some gap between the two. According to the Federal Reserve Bank of Cleveland, a rule of thumb says that the Treasury yield three months before the start of a recession tops the 10-year yield.
What is happening now?
At 1.75 per cent, the three-month yield is still well below the 10-year yield of 3.48 per cent, so there is no reversal.
But on Tuesday, the two-year Treasury yield briefly crossed the 10-year yield and then dipped below 3.42 per cent. The two yields first reversed in early April. Other, less-followed parts of the yield curve are already inverted. Although they are less consistent in predicting recessions as the three-month yield versus the 10-year, they show that the trend is shifting towards pessimism.
After the reversal in 2019, the global economy fell into recession in less than a year. However, the pandemic did not hit the bond market at that time. It was focused on global trade tensions and slowing growth.
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Now, the two-year yield is rising as investors become convinced the Fed will act more aggressively. The central bank has already pulled its key overnight rate from its record low to try to beat high inflation and is preparing to raise rates several times higher than usual.
A Friday report showed that inflation is becoming even stronger with many investors expecting the Fed to double or perhaps even triple the normal amount at its next meeting.
The two-year yield has more than quadrupled in 2022 alone. The 10-year yield has also increased, but not as quickly.
So the yield curve just reflects the thinking of the bond market?
It can also have a real impact on the economy. For example, banks make money by borrowing money at short-term rates and lending at long-term rates. When that gap widens, they make more in profit.
An inverted yield curve is complicated, however. If it cuts lending to banks – and thus growth opportunities for companies – it could help tighten the brakes on the economy.
Is this a perfect prophet?
No, an inverted yield curve has sent false positives before. For example, the three-month and 10-year yields reversed at the end of 1966, and the recession did not occur until the end of 1969.
Some market watchers have also suggested that the yield curve is less important now as drastic measures by the world’s central banks have distorted yields. Through the pandemic, the Federal Reserve bought trillions of dollars worth of bonds to keep long-term yields low, slashing rates overnight to nearly zero. It has recently begun allowing some of those bonds to slide off their balance sheets, which should put upward pressure on long-term yields.
should i panic?
Fed Chair Jerome Powell would say no. Earlier this year, he said he focused more on the first 18 months of the yield curve than the middle of the two-year and 10-year yields.
“That’s 100 percent of the explanatory power of the yield curve,” he said, and it’s not inverted.
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And even though the two-year and 10-year Treasury yields have reversed twice this year, they may be just a temporary blip rather than a permanent trend.
Many investors, however, are concerned about the prospect of a recession or “inflation,” which would be a painful combination of high unemployment and high inflation.
Of course, the bond market seems even more pessimistic. Just look at the yield curve.