There is currently a lot of turmoil regarding the yield curve. With large investors focusing on the reversal in 2- and 10-year government bond spreads, it is worth discussing the significance of this event as the yield curve has been used for decades as a leading indicator of economic prospects.
The reversal of the spread from 2 years to 10 years – i.e. when the 2-year government bond gives a higher yield than the 10-year government bond – is considered a harbinger of recessions. Indeed, the reversal predicted previous recessions of 1981, 1991, 2001, 2008, and 2020 (although COVID-19 was the catalyst for 2020). Nonetheless, investors watching the curve would have been ready for a recession, regardless of the true catalyst.
An inverted yield curve is an unusual event because, logically, investors should want to receive a higher return on long-term investments than on short-term ones.
However, when investors start to take a negative view of the economy, it leads them to start putting their money into bonds, which lowers yields. Specifically, investors are starting to buy longer-term bonds. The logic behind this is that recessions last an average of 18 months. Therefore, investors can at least theoretically guarantee income over this period.
Also, when it comes to lending activities, financial institutions “borrow short and lend long,” which means they will borrow a loan in a short term because it should have a lower interest rate. and lending for a longer term at a higher rate. The difference between borrowing and lending is the profit. A flattening yield curve reduces lending profits, which can lead to reduced lending activity.
Does an inverted 2-year and 10-year spread guarantee a recession? The answer is no because the yield has reversed twice without this being followed by a recession.
Why the 3-month and 10-year spread is a superior indicator
Although most investors constantly monitor the 2 and 10 spread, they often overlook the spread between 3-month and 10-year bonds.
Unlike the 2-10 spread, which has been wrong twice, a 3-month and 10-year reversal has never been wrong so far. The 8 recessions in the United States since 1970 (through 2020) have been preceded by an inverted yield curve (10 years versus 3 months).
The reason for this is likely that the 3-month yield closely tracks the federal funds rate, which is the interest rate banks charge each other to borrow or lend excess reserves overnight. For the 3-month yield to climb above the 10-year yield, it means that the Federal Reserve has raised the fed funds rate above the 10-year yield.
Since the 10-year yield is often used as a proxy for long-term growth expectations, an even higher fed funds rate means the cost of borrowing is higher than the expected growth rate. In our view, this would suggest that the Federal Reserve tightened too much, which ultimately led to a recession.
This leads to the phrase “bull markets don’t die of old age, but rather are killed by the Federal Reserve”.
Currently, the gap between the 3-month and the 10-year is very wide since the federal funds rate is still 0.25 to 0.50%. As of this writing, the 3-month yield is 0.53%, while the 10-year yield is 2.38%. However, the market expects the fed funds rate to rise very quickly based on fed funds futures.
The market expects it to be 2.49% by January 2023 (calculated as 100 – 97.51), less than a year from now.
If the 10-year rate remains close to its current levels, then we could see a reversal in January. With a 6-17 month lag between inversion and recession, we would likely see a recession by mid-2023 to mid-2024. However, that is if the reversal occurs.
Therefore, we currently do not see a recession in the cards for 2022. A more likely scenario is that we are just seeing slower growth and high quality stocks that can perform well in all market conditions will likely outperform. .