Tuesday, November 22, 2022
The shape of the U.S. Treasury yield curve is often looked at as a barometer for U.S. economic growth. More specifically, it reflects how the Federal Reserve (Fed) intends to stimulate or slow economic growth by cutting or raising its policy rate. Each tenor on the curve is roughly the expected policy rate plus or minus a term premium (the term premium represents the expected compensation for lending for longer periods of time). In “normal” times, the yield curve is upward sloping, meaning longer maturity Treasury yields are higher than shorter maturity Treasury yields. However, when, like now, inflationary pressures are apparent and the Fed wants to slow aggregate demand, shorter maturity securities could eventually out-yield longer maturity securities, inverting the yield curve.
The predictive record of yield curve inversion depends on which parts of the yield curve are inverted. Two popular yield curve indexes are the differences between the 2-year Treasury yield and the 10-year Treasury yield (2Y/10Y) and the 3-month T-Bill and the 10-year Treasury yield (3M/10Y). Of these two, the 2Y/10Y is the most popular within the financial media (likely because it tends to invert before the 3M/10Y), but the predictive signal of the 3M/10Y has been more robust.
The past six times the 2Y/10Y part of the yield curve inverted, a recession followed, on average, 18 months later. However, the length of time between the quickest time to recession (6 months) and the longest time until recession (nearly 36 months!) complicates the signal and in the Fed’s words, the relationship is probably spurious. As such, we (and the Fed) tend to put more credence on the 3M/10Y, which has had a better track record in predicting recessions with a lead time of about four to six quarters, but as few as two quarters ahead.
The 3M/10Y signal has predicted essentially every U.S. recession since 1950, with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967. There is also evidence that the predictive relationships exist in other countries, notably Germany, Canada, and the United Kingdom. Further, a signal that lasts only one day may be dismissed, but a signal that persists for a month or more should be looked at carefully. The current 3M/10Y inversion began in earnest in October, so using historical data as a guide and according to this quantitative metric, we’re likely at least two quarters away from recession. Finally, it’s also important to note that yield curve inversion does not provide much evidence in terms of length and/or magnitude of a potential recession. Over time, we’ve seen deep inversions with shallow recessions and shallow inversions with deep recessions. The signal only provides information on if a recession is likely over the next few quarters. We think any economic contraction will likely be a shallow one due to the continued strength of the consumer.
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