Wall Street’s most talked about recession indicator is sounding its loudest alarm in two decades, heightening investor concerns about the slowing U.S. economy.

This indicator is called the yield curve, and it is a way of showing how the interest rates of various US government bonds compare., including three-month treasury bills and two- and ten-year treasury bills.

Usually, bond investors expect to be paid more for tying up their money for a long time, so interest rates on short-term bonds are lower than those on longer-term bonds. Plotted on a graph, the different bond yields create an upward sloping line – the curve.

But from time to time, short-term rates exceed long-term rates. This negative relationship distorts the curve into what is called an inversion and signals that the normal situation in the world’s largest government bond market has been turned upside down.

An inversion preceded each American recession for half a century, it has therefore been considered a harbinger of economic catastrophe. And it’s happening now.

On Wednesday, the yield on two-year Treasury bills stood at 3.23%, above the 3.03% yield on 10-year bills. A year ago, by comparison, two-year yields were more than a percentage point lower than 10-year yields.

The Fed’s inflation mantra at the time was that inflation would be transitory, meaning the central bank saw no need to raise interest rates quickly. As a result, yields on short-term Treasury bills remained low.

But over the past nine months, the Fed has become increasingly concerned that inflation will not go away on its own, and it has begun to fight rapidly rising prices by rapidly raise interest rates. By next week, when the Fed is expected to raise rates again, its key rate will have jumped about 2.5 percentage points from near zero in March, pushing yields on US bonds higher. Short-term treasure like the two-year note.

Investors, on the other hand, are increasingly concerned that the central bank is going too far, slowing the economy to such an extent that it triggers a severe downturn. This concern is reflected in falling yields on longer-term Treasuries like the 10-year, which tell us more about investors’ expectations for growth.

That nervousness is mirrored in other markets too: stocks in the US have fallen nearly 17% year-to-date as investors reassess companies’ ability to weather a slowing economy; the price of copper, a global indicator due to its use in a range of consumer and industrial products, fell more than 25%; and the american dollara refuge in times of worry, is at its strongest in two decades.

What sets the yield curve apart is its predictive power, and the recessionary signal it’s sending out right now is stronger than it has been since late 2000, when the tech stock bubble had begun to erupt and a recession was only months away.

This recession hit in March 2001 and lasted about eight months. By the time it started, the yield curve had already returned to normal because policymakers had begun cutting interest rates in an attempt to restore the economy to health.

The yield curve also predicted the global financial crisis that began in December 2007initially reversing in late 2005 and remaining so until mid-2007.

This track record is why financial market investors have now noticed that the yield curve has inverted again.

“The yield curve is not gospel, but I think ignoring it is at your peril,” said Greg Peters, co-chief investment officer at asset manager PGIM Fixed Income.

On Wall Street, the most commonly referenced part of the yield curve is the relationship between two-year and 10-year yields, but some economists prefer to focus instead on the relationship between the yield of three-month bills and notes. in 10 years.

This group includes one of the pioneers of research on the predictive power of the yield curve.

Campbell Harvey, now an economics professor at Duke University, recalls being asked to develop a model that could predict US growth while a summer intern at the now-defunct Canadian mining company. Falconbridge in 1982.

Mr. Harvey turned to the yield curve, but the United States had already been in a recession for about a year and he was soon fired due to the economic climate.

It was only in the mid-1980s, when he had a doctorate. candidate for the University of Chicago, which he completed his research showing that a reversal in three-month and ten-year yields preceded the recessions that began in 1969, 1973, 1980 and 1981.

Mr. Harvey said he preferred to look at three-month yields because they are close to current conditions, while others noted that they more directly capture investors’ expectations of immediate policy changes. the Fed.

For most market watchers, the different ways of measuring the yield curve are all pointing broadly in the same direction, signaling slowing economic growth. They’re “different flavors,” said Bill O’Donnell, an interest rate strategist at Citibank, “but they’re still ice cream.”

Three-month yields remain below 10-year yields. So, by this measure, the yield curve has not inverted, but the gap between them has rapidly narrowed as worries about a slowdown have intensified. As of Wednesday, the difference between the two yields had fallen from more than two percentage points in May to around 0.5 percentage points, the lowest since the pandemic-induced downturn in 2020.

Some analysts and investors say the focus on the yield curve as a popular signal of recession is overblown.

A common criticism is that the yield curve tells us little about the onset of a recession, only that there probably will be one. The average time to a recession after two-year yields top 10-year yields is 19 months, according to data from Deutsche Bank. But the range is six months to four years.

The economy and financial markets have also evolved since the financial crisis of 2008, when the model was last in vogue. The Fed’s balance sheet has swelled as it has repeatedly bought Treasuries and mortgage bonds to help prop up financial markets, and some analysts say those purchases can skew the yield curve.

These are the two points that Mr. Harvey accepts. The yield curve is a simple way to predict the trajectory of US growth and the potential for recession. It has proven itself but it is not perfect.

He suggests using it in conjunction with surveys of the economic expectations of CFOswhich typically reduce business spending as they become more concerned about the economy.

He also pointed to corporate borrowing costs as an indicator of the risk investors perceive in lending to private companies. These costs tend to increase as the economy slows. These two measures are currently telling the same story: risk is increasing and expectations of a downturn are increasing.

“If I was back in my summer internship, would I just look at the yield curve? No,” Mr. Harvey said.

But that doesn’t mean it’s ceased to be a useful indicator either.

“It’s more than helpful. It’s very valuable,” Mr. Harvey said. “It behooves the leaders of any business to take the yield curve as a negative signal and engage in risk management. And for people too. Now is not the time to max out your credit card on an expensive vacation.

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By sahil

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