US yield curve inverts in possible recession signal

A closely watched recession signal flashed red on Tuesday, as investors fretted that the Federal Reserve’s efforts to tame inflation will bring about a sharp slowdown in US economic activity.

Two-year Treasury note yields rose above those of the 10-year for the first time since August 2019, inverting a portion of the yield curve monitored closely by Wall Street and policymakers. Inversions typically signal malaise about the economy’s long-term growth prospects and have preceded every US recession in the past 50 years.

Typically, a recession has followed in the two years after an inversion of this measure of the yield curve.

Two-year yields, which move with interest rate expectations, rose as high as 2.45 per cent, the highest level since March 2019. The two-year yield has risen by 1.64 percentage points this year as the US central bank has tightened monetary policy, including its first rate rise since 2018 in order to combat inflation that’s at a 40-year high.

The 10-year yield, which moves with inflation and growth expectations, fell as low as 2.38 per cent. The benchmark yield has also risen this year, albeit at a slower pace, as tighter Fed policy has curtailed inflation and growth forecasts.

After inverting, the gap quickly widened and the yield curve turned positive again, where it hovered at about 0.02 percentage points. At the start of the year, it stood at 0.77 percentage points.

The spread between five- and 30-year yields, another measure of the yield curve, on Monday inverted for the first time since 2006.

Investors argue, however, that the inversion may not be as reliable a recession indicator this time round because the Fed’s massive bond purchases during the coronavirus crisis have skewed the yields.

“The yield curve inversion is a factor that will worry markets,” said Gennadiy Goldberg, a US rates analyst at TD Securities. But, he noted that these inversions “may also be distorted due to the enormous Covid quantitative easing programme undertaken by the Fed”.

The Fed, as part of its intervention in financial markets during the market collapse in March 2020, began buying huge swaths of US government debt to shore up the economy. The central bank this month ended that $120bn-a-month bond-buying programme and as it has pulled back, the flood of Treasuries to the market has driven prices lower and yields higher.

Expectations have increased that the Fed will ratchet higher the pace at which it is tightening monetary policy, with investors girding for the central bank to deliver a half-point rate increase as early as its meeting in May. The central bank typically moves in quarter-point increments, as it did earlier this month, but mounting inflationary pressures have raised the risk of more aggressive action.

Some officials have also suggested rates this year need to rise above the so-called neutral level that neither aids or hinders growth and that is forecast to be 2.4 per cent.

The effects of the Fed’s intervention may mean that this yield curve inversion is one driven by technical factors in the market, rather than economic fundamentals.

The traditional signs of a slowing economy are also not yet present. The US economy last year grew at the fastest annual pace since 1984 as it rebounded from the pandemic-driven recession, which lasted for the first two quarters of 2020. The labour market has also roared back, with strong jobs growth reported in recent months.

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