Derrick O. from Idaho Falls, ID asks: Hi Mitch, I saw an article last week about an “extreme yield curve inversion,” which is supposed to be a strong signal of a recession. Do you agree that this is the case? Thank you.
Mitch’s Response:
Thanks for emailing your question. The article you sent is accurate in reference to the yield curve inversion being larger than usual, which is true no matter your preferred measure of the yield curve.
The financial media mostly focuses on the difference between the 2-year Treasury bond yield and the 10-year Treasury bond yield. When the 2-year yield goes above the 10-year yield – meaning investors get paid more yield over a shorter time frame – the curve is inverted. By that measure, and as of the end of last week, the 2-year was 0.78% higher than the 10-year, market the largest negative gap since late 1981. I think this is probably where the “extreme” characterization comes in.1
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My preferred measure of the yield curve is also the one the Federal Reserve focuses on, which measures the difference between the 3-month U.S. Treasury bond yield and the 10-year U.S. Treasury bond yield. This measure of the yield curve is more meaningful, in my view, because it paints a clearer picture of net interest margins being earned by banks. Naturally, banks do not want to see short-term rates rise above long-term rates, because it crimps profitability on loans. That’s also why a yield curve inversion is viewed as a negative for the economy.
By my preferred yield curve measure, the curve is also inverted, but I would stop short of calling it “extreme.” As I write, the 3-month U.S. Treasury bond yields 4.34%, and the 10-year U.S. Treasury bond yields 3.51%.3 There is historical evidence that this is a meaningful signal that a recession is either underway or nigh, as the chart below shows:
U.S. Yield Curve (10-Year U.S. Treasury Minus 3-Month)
So, to answer your question, I think that a recession is indeed a very distinct possibility. But from an investment standpoint, as I’ve written a few times before, I think stocks have already priced in future economic weakness with the bear market. I also think that the jobs market and consumer spending will buttress the economy as activity slows, such that the recession should be mild and perhaps not even noticed by many.
Another possibility to consider is that the inverted yield curve may just be investors pricing-in a future with lower inflation, not an impending economic downturn. On one level, when longer-term Treasury bond yields are lower than short-term yields, it means investors think the fed-funds rate will be lower in the future than it is now – likely because the Fed will need to cut rates to revive a slowing economy. The market may be betting that inflation will be low enough next year to allow the Fed to take this action.
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Disclosure
2 Zacks Investment Management reserves the right to amend the terms or rescind the free: A Recession is Coming: 6 Insights to Know Now So You’re Prepared offer at any time and for any reason at its discretion.
3 U.S. Department of Treasury. 2022. https://home.treasury.gov/resource-center/data-chart-center/interest-rates/TextView?type=daily_treasury_yield_curve&field_tdr_date_value=2022
4 Fred Economic Data. December 5, 2022. https://fred.stlouisfed.org/series/T10Y3M#
5 Zacks Investment Management reserves the right to amend the terms or rescind the free: A Recession is Coming: 6 Insights to Know Now So You’re Prepared offer at any time and for any reason at its discretion.
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