Economists often look to the US Treasury bond market for clues about when a recession might come. Specifically, they examine the so-called yield curve. When it is “inverted,” as it has been since about mid-2022, that almost always means a US recession is looming. But by mid-2023, the curve began to “dis-invert” — or steepen in industry parlance — in a way that raised the question of whether the US had managed to dodge a recession or whether one was about to start.
1. What’s the yield curve telling us?
Things are definitely on the move, with rapid shifts in expectations for interest rates. That is on display with shifts in the yield curve — the graph plotting the level of interest rates on federal government bonds maturing anywhere from one month to 30 years. On Oct 5 and Oct 12, yields on longer-dated bonds pushed sharply higher on expectations that the US economy’s strength means the Fed will hold rates “higher for longer”.
2. So this is about the longer term?
Yes. Most of the time, bond investors demand a higher yield, or return, for the greater uncertainty that comes with locking away their money for longer periods. So yield curves usually slope upward. The most alarming state is a yield curve inversion, which happens when, say, 10-year Treasury bonds start yielding less than two-year bonds. It is a sign that bond investors expect interest rates to decline in the longer term, a reflection of a slowing economy and one that in the past has signalled a recession. That was the state of things before the curve began reversing the scale of its inversion and returning toward a more normal one.
3. What could that shift mean?
Typically when the yield curve begins to reverse the inversion it means the economy is getting closer to a downturn, and short-term yields often drop in anticipation that the Fed is poised to start slashing rates to jump-start growth. Traders call that a “bull steepening”. But this time is different. Rather than the curve changing shape because short-term rates are falling, it is changing shape because longer yields are surging. That process is called a “bear steepening”.
4. Why is that distinction important?
Longer-dated yields rising more quickly than shorter-dated ones means the steepening is not happening for the usual pre-recession reason. Instead, investors are concluding that policymakers are in no rush to cut rates, given how strong the economy has been. Long-bond yields are pushing up to reflect those expectations. On top of that, the supply of Treasury bonds has surged as the federal government’s deficit keeps growing, likely adding to the downward pressure on prices.
5. Where does that leave us?
If it looked at first glance as though the shift in the yield curve was a solidly positive sign — one indicating that the economy is now at less risk of a recession than it was — that is probably not the case. True, it shows traders aren’t expecting the Fed to shift into firefighting mode soon. Even so, it is almost certain to further dampen the economy as it ripples through to mortgages, credit cards and business loans. That will tighten financial conditions further, which may be a welcome development for the Fed. The risk, though, is that it hits the brakes so hard that the economy stalls completely. — Bloomberg Quicktake
