A yield curve inverts when long-term interest rates drop below short-term rates, indicating that investors are moving money away from short-term bonds and into long-term ones. This suggests that the market as a whole is becoming more pessimistic about the economic prospects for the near future.
When looking at inverted yield curve, it can be any pair of long-term interest rates and short-term interest rates. In this article, we will look at the inverted yield curve between 10-year and 2-year treasury bond yields.
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| Figure 1. SPY Monthly Chart (Courtesy: stockcharts.com) |
Inverted Yield Curve Precedes the Recession
The Fed's ongoing rate hiking will eventually trigger the next recession. Historically, an inverted yield curve - the difference between 10-year and 2-year bond yields - has been one of the single-best leading indicators of an impending downturn.
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| Figure 2. Inverted Yield Curve Precedes the Recession |
The Slope of the Yield Curve
Conceptually, the slope of the yield curve is a rough approximation of the stance of U.S. monetary policy. The Federal Reserve controls the level of short-term interest rates. Markets determine the level of long-term interest rates based on underlying macro fundamentals.
Therefore, the slope of the yield curve can tell us a lot about the market's expectations for economic growth and inflation. There are three basic shapes the yield curve can take:
- Normal, upward sloping yield curve
- Economy is growing and investors are confident
- Steep yield curve
- A sharply upward sloping, or steep yield curve, has often preceded an economic upturn
- Steep yield curve that is so beneficial to banks and levered bond investments.
- Flat yield curve
- Warning sign that an economy is under duress
- Inverted yield Curve
- The economic outlook is very bleak
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| Figure 3. Yield curve between 10Y and 2Y Treasury Yield (Courtesy: stockcharts.com) |
Inverted Yield Curve between $UST10Y and $UST2Y
This part of the yield curve is the most closely watched and typically given the most credence by investors that the economy could be heading for a downturn when it inverts.
On Aug. 28, 2019, the 10-year/two-year spread briefly went negative. The U.S. economy suffered a two-month recession in February and March 2020 amid the outbreak of the COVID-19 pandemic, which could not have been a consideration embedded in bond prices six months earlier.
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| Figure 4. Average number of days market bottom after the start of NBER recession (Courtesy: @MrBlonde_macro) |
S&P 500 around NBER Recession
Inverted yield curve normally precedes the recession—note that 2y10y inversion happened since July 2022. However, as said by Simon White at Variant Perception in [44]:
The lead time between an inversion and the onset of an actual recession is highly variable, White stated, anywhere from 4 to 6 months to 2 years before a recession takes hold.
NBER doesn’t declare, let alone date a recession until well into the recovery. Otherwise Figure 4 would be a great tool for timing market bottom. However, we can still use Figure 2 as guideposts—recessions won't start until negative yield curve climbs back up again.
On 10/22/2022, here are some of analysts' comments on the current market:[46]
First, it was Morgan Stanley's uber-bear Michael Wilson, who started off the week by flipping (tactically) bullish and calling for 4,150. Then, BofA's permabear Michael Hartnett pointed to " macro capitulation, investor capitulation, and start of policy capitulation" and predicted that a near-term bottom is here, as stocks rise then fall, before fully bottoming some time in H1 2023 when the next bull market begins.
References
- Cleveland Financial Stress Index
- Fed "Workhorse" Model Says Odds of Recession in Next Year Only 3.56%; What are the Real Odds?
- The report failed to mention the most practical of practical issues: It's damn hard for the 3-month to invert with 10-year treasuries when the Fed has artificially held short-term yields closet to zero.
- The Yield Curve as a Leading Indicator: Some Practical Issues (New York Fed)
- The Yield Curve as a Leading Indicator (New York Fed)
- Looking Beyond Circular Feedback Loops In The Market
- On The Dispersion, Or Lack Thereof, of Economic Weakness (Tim Duy's Fed Watch)
- So You Think A Recession Is Imminent, Yield Curve Edition (Tim Duy's Fed Watch)
- So You Think A Recession Is Imminent, Employment Edition (Tim Duy's Fed Watch)
- 3 Charts All Investors Should See
- US credits
- Global sector earnings momentum
- Global manufacturing activity
- VIX Outside of `Red Zone' Indicates No Recession, Goldman Says
- The “Red Zone” happens when the VIX is above 25 and climbing, which historically coincides with flat or negative U.S. gross domestic product.
- A hedge fund manager shares the 10 things that could surprise the market this year (good)
- A Recession Is On My Mind (Steven Hansen)
- The Yield Curve Says No Recession
- Labor Indicators: Some of Today's Trends Pre-Date the Great Recession (Fed Reserve Bank of St. Louis)
- Why Is Economic Growth So Slow?
- Portion of US Treasury Yield Curve Inverts
- Altitude Adjustment: Investing During a Period of Lower Returns and Higher Volatility (PIMCO)
- We expect less consistency in the negative correlation between stocks and bonds relative to the past decade.
- We believe currency movements will play a much larger role in determining portfolio outcomes.
- We suggest investors not ignore the reduction in market liquidity and its potential consequences.
- Our outlook for the global economy is for sideways growth with an uptick in inflation.
- Are we nearing the threshold of the next global recession? At PIMCO, we don’t think so.
- Currency Wars and a Job Gain Recession?
- The yield curve still works and 5s10s is one measure that is less influenced by the Fed.
- Worthy Of Investor Attention: The Long-Term Debt Cycle
- 22 Signs That The Global Economic Turmoil We Have Seen So Far In 2016 Is Just The Beginning
- Smelling the Recession
- Voluntary Job-Quitting Hits Highest Level in Nine Years
- 13 Charts On The Likelihood Of A Recession
- Inflation And GDP Growth Rise; Bond Yields Must Follow
- The 10 Largest “Relative” Trade Networks (EAST ASIA, EUROPE, INDIA, NORTH AMERICA )
- Singapore's export slump is a worrying sign for the global economy
- As a global barometer for the health of the global economy, Singapore continues to paint a bleak picture at present.
- Dual Risk Out Of China (04/24/2016)
- Weak Eurozone Manufacturing Data Reinforces ECB's Impotence
- These 9 charts explain the global slowdown and why central banks are powerless
- An Arbiter of Recessions Sees ‘Clouds on the Horizon’ for the U.S. Economy
- One of the biggest warning signs of the financial crisis is flashing again — but this time is different
- An increase in the Libor, the typical thinking goes, means that banks see lending to their fellow financial institutions as more risky and signals the possibility of financial instability.
- Surge in Global Economic Surprises, Business Confidence Continues
- Hard-Boiled vs Soft-Boiled Economic Egg Debate: Cracking the Shells
- Closing In On ZERO Growth
- Sotheby's As Economic Indicator
- While Sotheby's caters mostly to people who have too much money lying around that they feel the need to spend it on paintings and pricey tchotchkes, in the past the stock's performance has been cited as a relatively good predictor of the business cycle.
- Taking Stock (Tim Duy)
- Here's The Biggest Threat To The Economy And The Bull Market (good)
- Are Recession Risks Increasing In The U.S.?
- Why The Stock Market Will Peak On May 10, 2019 At 4:00 PM EST
- Investment Basics: Yield Curve (Pimco)
- Why Does the Yield Curve Typically Invert before Recessions?
- St. Louis Fed Director of Research Chris Waller discusses two reasons why: if people expect real interest rates to fall (which is usually viewed as a pessimistic outlook for the economy) and/or if they expect inflation to fall.
- Prepare For A Deep Recession And Bear Market
- Leading Indicators Suggest Recovery in 2020
- The World's Top Experts On Money & The Markets
- Jim Grant, Lacy Hunt, Luke Gromen, James Rickards, Danielle DiMartino Booth, Brent Johnson, Lance Roberts, Tavi Costa, Rick Rule
- "The Pain Trade Is To The Upside": 10 Reasons From Goldman's Trading Desk For A November Meltup
- 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity
- The strongest indicator of an upcoming recession just hit. The 10 year / 3 month yield curve just inverted. This has led to a recession 100% of the time within 6 to 18 months - but no earlier than 6 months out. Get ready for a major #recession next year.
