What Is the Yield Curve Saying Now?

By:

Head of SPDR Americas Research

  • A yield curve inversion has predated the last nine recessions.
  • But does the most recent inversion portend a recession? For now, no.
  • The duration of the inversion matters, not just the inversion itself.

The most followed yield curve term spread is the difference between the US 10-year yield and the US 2-year yield. The yield curve is said to be inverted when the 2-year rate yields more than the longer 10-year rate.

Research shows that an inverted yield curve has predated the last nine recessions, with one false positive.1 It’s usually talked about as a reliable indicator that a recession may be on the horizon.

While the fact that an inversion has preceded every recession over the past 70 years is noteworthy, there is more to the story. And the current market has a “this time is different” feel.

The slope of the yield curve reflects information about current and expected future monetary policy actions (the short end) as well as the market’s attitude towards risks, growth, and inflation (the long end). Both are linked to the expectations of future business cycle outcomes.

Right now, as the Federal Reserve (Fed) seeks to reign in elevated inflation levels, it is expected to continue to hike rates for the rest of the year. The market is expecting at least eight more increases in 2022.2 This would put the Federal Funds Rate at an implied level of 2.4%.3

This has pushed short-term rates up 160 percentage points over the last three months to 2.34%.4 Long-term rates, however, have also risen (a bear flattener) by 88 percentage points to 2.39%,5 as growth and inflation continue to remain above trend and investors are seeking a premium for lending their money that far out in the future.

Yet, these two moves have compressed the spread. In a recent client meeting I was asked, “What is the yield curve telling you?” I responded that both rates are nearly the same — and I was serious. Right now, the yield curve is not telling me much about a looming recession, the question the client was really asking.

There are two factors at play:

  1. The historical precedent has a large error term.
  2. Real rates are currently negative and quantitative easing (QE) has suppressed the long end.

The Yield Curve’s Historical Precedent

Much has been written about the relationship between interest rates and the economy. Rudebusch and Williams (2009) showed that an inverted yield curve reliably predicts low future output growth and indicates a high probability of recession. Estrella and Mishkin (1997) found that this relationship holds both in the United States and for multiple other advanced economies.

As a result, the term spread metric is closely watched by professional forecasters and policymakers. The numbers also back it up. The chart below shows that, using a spliced version of the US 1-year and US 2-year yield (given the latter didn’t start trading until the 1970’s) from January 1955 to now, an inverted yield curve has predated all nine recessions.

With just one false positive in 1965, that’s a 90% hit rate overall. In 1965, the economy did enter a slowdown — not a recession — consistent with a portion of the economic theory above about the yield curve portending slower growth.

Monthly View of Yield Curve and Recessions

Monthly View of Yield Curve and Recessions

But the delay between the term spread turning negative and the beginning of a recession has ranged anywhere from six to 24 months. That’s quite a gap! That means the yield curve could invert and, at a minimum, an entire baseball season could be played before a recession even began. At the long end, it could be two years before a recession hits. So while the yield curve inversion’s hit rate is high, its timing leaves a lot to be desired.

With so many other variables impacting the pace of the economy over a six- or 24-month duration, it’s hard to conclude that an inverted yield curve indicates a recession is imminent. While the yield curve inverted in 2019 and a recession followed in 2020, the reason for the recession was a global pandemic. That’s not something the yield curve could have forecasted.

Click here to read the full article

Footnotes

1 Economic Forecasts with the Yield Curve, FRBSF Economic Letter, March 5, 2018.
2 Bloomberg Finance L.P., as of March 30, 2022, based on implied futures pricing.
3 Bloomberg Finance L.P., as of March 30, 2022, based on implied futures pricing.
4 Bloomberg Finance L.P., as of March 30, 2022.
5 Bloomberg Finance L.P., as of March 30, 2022.
6 Bloomberg Finance L.P., as of March 30, 2022, based on consensus forecasts.
7 Bloomberg Finance L.P., as of March 30, 2022, based on calculations by SPDR Americas Research.
8 Bloomberg Finance L.P., as of March 30, 2022, based on the holdings reported by the Federal Reserve.

Glossary

Bear Flattener
Bear flattener refers to the convergence of interest rates along the yield curve as short-term rates rise faster than long-term rates.

Originally Posted April 1, 2022 – What Is the Yield Curve Saying Now?

The views expressed in this material are the views of the SPDR Research and Strategy team through the period ended March 30, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.

Unless otherwise noted, all data and statistical information were obtained from Bloomberg LP and SSGA as of March 30, 2022. Data in tables have been rounded to whole numbers, except for percentages, which have been rounded to the nearest tenth of a percent.

All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Investing involves risk including the risk of loss of principal.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.

Disclosure: Interactive Brokers

Information posted on IBKR Traders’ Insight that is provided by third-parties and not by Interactive Brokers does NOT constitute a recommendation by Interactive Brokers that you should contract for the services of that third party. Third-party participants who contribute to IBKR Traders’ Insight are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from State Street Global Advisors and is being posted with permission from State Street Global Advisors. The views expressed in this material are solely those of the author and/or State Street Global Advisors and IBKR is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation to buy, sell or hold such security. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

In accordance with EU regulation: The statements in this document shall not be considered as an objective or independent explanation of the matters. Please note that this document (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and (b) is not subject to any prohibition on dealing ahead of the dissemination or publication of investment research.

Any trading symbols displayed are for illustrative purposes only and are not intended to portray recommendations.