Bonds are sending a potentially ominous signal about the U.S. economy. The 10-year Treasury yield fell below the 3-month Treasury yield on March 22 for the first time since August 2007. Yield curve inversion, or long-term rates falling below short-term rates, has preceded each of the nine recessions going back to 1955.
Before bracing for an economic downturn, however, it’s important to understand the catalysts. As shown in the LPL Chart of the Day, the 10-year yield fell the most in a week since June 2016 amid immense buying pressure in U.S. debt, spurred by falling rates in other sovereign debt and negative German bund yields.
The Federal Reserve’s (Fed) policy U-turn has also played a role. The Fed’s new dot plot showed policymakers expect slower growth this year and next, even amid rates at or lower than current levels. Taking some pressure off rates and the tightening financial conditions was part of the Fed’s intended effect, but the bond market read policymakers’ outlook as especially gloomy, and the 10-year yield fell to a 14-month low.
While economic conditions are softening, fixed income’s reaction to recent events may have been overblown. To us, the Fed’s dots are more of a reflection of the lack of clarity than a judgment on the economic outlook. The Fed is data dependent, and economic data, while sound overall, have noticeably weakened this quarter.
“The bond market is sending cautious signals, but we see plenty of evidence that solid U.S. fundamentals are intact even as the global economy struggles with ongoing trade and political risks,” said LPL Research Chief Investment Strategist John Lynch. “We expect U.S. growth to stabilize and inflation to creep higher as the risks subside, which together would likely begin pushing 10-year yields back up toward 3%.”
The inversion between the 3-month and 10-year Treasury yields gives us pause, but we would become more concerned if that negative spread were to widen significantly. Historically, the spread between the 3-month and 10-year yields has become much more predictive of a recession at -50 basis points (-.50%). The U.S. economy has also peaked an average of 16 months after an initial yield curve inversion, so based on history and encouraging signals in leading data we track, we do not think a recession is imminent.
For more of our thoughts, check out this week’s Weekly Economic Commentary.
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Yield Spread is the difference between yields on differing debt instruments, calculated by deducting the yield of one instrument from another. The higher the yield spread, the greater the difference between the yields offered by each instrument. The spread can be measured between debt instruments of differing maturities, credit ratings and risk.
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