Treasury Yield Reversal Signals Economic Crisis

Comments hawks from Federal Reserve Chairman Jerome Powell Efforts to control inflation have worsened the inversion of the bond yield curve for US Treasury securities, which many on Wall Street see as a leading indicator of a coming recession.

Powell presented the Fed’s semi-annual update to Congress on Monetary Policy this week and told lawmakers that the central bank will have to raise interest rates more than expected as inflation has remained consistently high despite a series of rate hikes amid strong economic growth.

One of the most watched spreads on the yield curve is between two-year and 10-year Treasury bills, known as the “2/10 spread”. The 2/10 spread reversed in July 2022 – just four months after the Fed started raising rates last March.

The 2/10 spread hit 103.1 basis points on Tuesday – the biggest reversal between these stocks since September 1981, when the economy was in recession as the Fed raised interest rates to rein in runaway inflation – and widened to around 107 basis points on Wednesday. .

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Treasury yield curves

This graph shows the current inversion of the Treasury yield curve (green) compared to more typical pre-pandemic yield curves in January 2020 (blue) and about a year after the start of the pandemic in March 2021 ( orange). (Courtesy of BondCliQ)

For context, the 2/10 spread has averaged about 84 basis points over the past few decades. The 2/10 spread peaked in March 2010 when it reached 280 basis points as the economy began to slowly recover from the financial crisis. The deepest inversion of the 2/10 yield curve occurred in March 1980 when it reached minus 199 basis points.

Paul Faust, Co-Head of Strategic Accounts at BondCliQ, said FOX Business“The current inversion in the US Treasury curve signals market concern about near-term inflationary pressures and the need for the Fed to act, coupled with their concern about recession or economic weakness. longer-term economic expansion.”

Powell said the Fed has yet to make a decision on the size of the next round of rate hikes that will be announced after the central bank’s March meeting. The Fed slowed the pace of rate hikes after its last two meetings, opting for a 25 basis point hike at its February meeting, which lifted the benchmark fed funds rate to a range of 4.5 % to 4.75%. This followed a 50 basis point hike in December that was preceded by four consecutive increases of 75 basis points.

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Federal Reserve Chairman Jerome Powell

The inversion of the bond yield curve between two-year and 10-year Treasuries hit its highest level since 1981 this week, as Federal Reserve Chairman Jerome Powell testified before Congress on monetary policy. (AP Photo/Manuel Balce Ceneta/AP Images)

Rising interest rates on treasury bills mean that rates for car loans, credit cards and mortgages will all tend to rise as well, driving up costs for borrowers and consumers. They also encourage investors to leave the stock markets and turn to treasury bills, as they offer more attractive interest rates.

“Investors have historically compared 10-year Treasury yields to the S&P dividend yield when making investment decisions,” Faust said. “The dividend yield on the S&P is still near all-time lows at around 1.3% versus 10-year yields near 4%, a 15-year high. Given recession concerns signaled by the Treasury market , the equity market appears to be most at risk of a correction.”

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The Federal Reserve is expected to announce its latest interest rate hike at the central bank meeting later this month. (HDR picture) (iStock/iStock)

Yield curves and their relationship to recessions

Typically, longer-term treasury bills carry higher interest rates than short-term securities because there is greater uncertainty about the economy over a longer period of time, so treasury bills with maturities of 10 years or more in futures command a risk premium in the form of higher interest rates. This means that usually the yield curve gradually rises in tandem with the duration of a given Treasury security.

Yield curve inversions occur rarely, but are seen as a predictor of a coming recession, as they suggest that investors believe economic growth will slow in the short term and that over a longer period, the Fed will have to back to lower interest rates. to stimulate growth.

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The Federal Reserve Bank of San Francisco released research in 2018 that found that every recession since 1955 has been preceded by a 2/10 spread reversal that occurred six to 24 months before the recession, and it emitted only one false signal during this period. frame.

Anu Gagger, global investment strategist for Commonwealth Financial Network, found 28 reversals of the 2/10 spread dating back to 1900, and recessions followed in 22 of those cases. She said in June that the last six recessions started an average of six to 36 months after the curve inverted.

Megan Henney of Fox Business and Reuters contributed to this report.

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