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The bond market is sounding the alarm for the US economy.
This warning sign is called an “inverted yield curve”. These reversals in the bond market have been reliable predictors of past recessions. Part of the yield curve inverted on Monday.
However, an economic slowdown is not guaranteed. Some economists think the warning is a false alarm.
Here’s what you need to know.
What is an inverted yield curve?
Why is this a warning sign?
An inversion of the yield curve does not trigger a recession. Instead, it suggests bond investors are worried about the long-term outlook for the economy, Roth said.
Investors pay the most attention to the spread between the 2-year US Treasury and the 10-year US Treasury. This curve does not yet flash a warning sign.
However, 5- and 30-year US Treasury yields reversed on Monday, the first time since 2006, before the Great Recession.
“It doesn’t mean a recession is coming,” Roth said of the reversals. “It just reflects concerns about the future economy.”
Yield curves for 2- and 10-year Treasuries inverted before the last seven recessions since 1970, according to Roth.
However, the data suggests that a recession is unlikely to be imminent if one materializes. It took 17 months after the bond market reversal for a downturn to begin, on average. (Roth’s analysis treats the double-dip recession of the 1980s as a single downturn.)
There was a false alarm in 1998, she says. There was also a reversal just before the Covid-19 pandemic, but Roth said this could arguably also be seen as a false alarm, as bond investors could not have predicted this health crisis.
“It doesn’t work all the time, but it has a high hit rate to portend a future recession,” said Brian Luke, Americas head of fixed income at S&P Dow Jones Indices.
Interest rates and bonds
The Federal Reserve, the US central bank, has a big influence on bond yields.
The Fed’s policy (namely, its benchmark interest rate) generally has a greater direct impact on short-term bond yields compared to those on longer-term bonds, Luke said.
Long-term bonds do not necessarily move in tandem with the Fed’s benchmark index (known as the fed funds rate). Instead, investors’ expectations of future Fed policy have more bearing on long-term bonds, Luke said.
The US central bank raised its key rate in March to calm the economy and contain inflation, which is at its highest level in 40 years. It is expected to do much more this year.
This helped push up short-term bond yields. Yields on long-term bonds also rose, but to a lesser extent.
The 10-year Treasury yield was about 0.13% higher than the 2-year bond on Monday. The gap was much larger (0.8%) at the start of 2022.
Investors seem concerned about a so-called “hard landing”, according to market experts. This would happen if the Fed raised interest rates too aggressively to control inflation and accidentally triggered a recession.
During a downturn, the Fed cuts its benchmark interest rate to stimulate economic growth. (Lowering rates reduce borrowing costs for individuals and businesses, while raising them has the opposite effect.)
Thus, an inverted yield curve suggests that investors are pricing in a recession in the future and are therefore pricing in the expectation of a longer-term Fed rate cut.
“It’s the bond market trying to figure out the future path of interest rates,” said Preston Caldwell, head of U.S. economics at Morningstar.
Treasury bills are considered a safe asset because the United States is unlikely to default on its debt. Investors’ flight to safety (and therefore higher demand) for long-term bonds also serves to suppress their yield, Luke said.
Is a recession likely?
A recession is not a foregone conclusion.
It is possible that the Federal Reserve calibrates its interest rate policy appropriately and achieves its “soft landing” objective, whereby it reduces inflation and does not cause an economic contraction. The war in Ukraine has complicated the picture, fueling a spike in the prices of basic commodities like oil and food.
“There’s nothing magical about a yield curve inversion,” Caldwell said, adding that it doesn’t mean the economy is going to contract. “It’s not a light switch that’s flipped.”
However, many economists have adjusted their economic forecasts. JP Morgan assesses recession risks at around 30% to 35%, above the historical average of around 15%, Roth said.