What Is the Yield Curve? Wall Street’s Recession Alarm Is Ringing.

Wall Street’s most talked-about recession indicator has sounded the biggest alarm in 20 years, raising investor concerns that the US economy is heading for a slowdown.

This indicator, called the yield curve, is a way of showing how interest rates on various US Treasuries are compared., Especially 3 month invoices, and 2 and 10 year Treasury notes.

Short-term bond rates are usually lower than long-term bond rates because bond investors usually expect to receive more payments by fixing their funds over the long term. The various yields of bonds plotted on the chart create an upward slope, or curve.

However, sometimes short-term interest rates exceed long-term interest rates. The negative relationship distorts the so-called reversal curve, indicating that the normal situation in the world’s largest government bond market has reversed.

Over the last half century, a reversal has occurred prior to all US recessions, which is considered a precursor to economic collapse. And that’s happening now.

The yield curve has predictive power not found in other markets.

The yield on 2-year government bonds on Wednesday was 3.23%, which is higher than the 10-year bond of 3.03%. Compared to a year ago, the two-year yield was more than one percentage point lower than the ten-year yield.

The Fed’s inflation mantra at the time meant that inflation was temporary and the central bank was unaware of the need to raise interest rates rapidly. As a result, yields on short-term government bonds remained low.

But over the past nine months, the Fed has begun to tackle sharp inflation by raising interest rates, raising concerns that inflation will not decline naturally. By next week, when the Fed is expected to raise interest rates again, its policy rate has risen about 2.5 percentage points from near zero in March, which has boosted yields on short-term government bonds such as two-year bonds.

Investors, on the other hand, are becoming more and more afraid that central banks will overshoot and slow the economy to the point of causing a serious recession. This concern is reflected in long-term Treasury yield declines, such as 10 years, detailing investor expectations for growth.

This nervousness is reflected in other markets as well. US equities have fallen nearly 17% so far this year as investors reassessed the company’s ability to withstand the slowdown in the economy. Copper prices have fallen by more than 25% globally as they are used in array consumer and industrial products. And the US dollar, a paradise of worries, is the strongest in 20 years.

It’s that predictive power that sets the yield curve apart, and the recession signals we’re currently sending are more than they were in late 2000, when the tech stock bubble began to burst and the recession was just a few months away. It’s powerful.

The recession occurred in March 2001 and lasted for about eight months. By the time it began, the yield curve had already returned to normal as policymakers began lowering interest rates in an attempt to restore the economy to a healthy state.

The yield curve is also Global financial crisis that began in December 2007The first reversal in late 2005 and will remain in that state until mid-2007.

That track record is why investors across financial markets are paying attention as the yield curve reverses again.

“The yield curve isn’t the gospel, but I think it ignores your own risk,” said Greg Peters, co-chief investment officer of asset manager PGIM Bonds.

But what part of the yield curve is important?

The most commonly referred to yield curve portion of Wall Street is the relationship between 2-year and 10-year yields, but some economists instead have 3-month invoices and 10-year note yields. I like to focus on relationships.

The group includes one of the pioneers in research on the predictive power of the yield curve.

Campbell Harvey, now a professor of economics at Duke University, developed a model that could predict U.S. growth during a summer internship at the now-closed Canadian mining company Falconbridge in 1982. I remember being asked.

Harvey turned to the yield curve, but the United States had already been in recession for about a year and was quickly fired due to economic conditions.

He received his PhD until the mid-1980s. He is a candidate for the University of Chicago and has completed his study showing that yields of three months and ten years have reversed prior to the recession that began in 1969, 1973, 1980, and 1981.

Harvey said he preferred to consider a three-month yield because it’s close to the current situation, but others have more directly expected investors’ expectations for immediate changes in the Fed’s policies. He said he was catching.

For most market watchers, the different methods of measuring the yield curve all point broadly in the same direction, indicating slowing economic growth. “These are’different flavors’, but they’re all ice cream,” said Bill O’Donnell, interest rate strategist at Citibank.

The 3-month yield is below the 10-year yield. Therefore, although the yield curve is not reversed in this indicator, the gap between the yield curves is shrinking rapidly due to growing concerns about deceleration. By Wednesday, the difference between the two yields had dropped from more than 2 percentage points in May to about 0.5 percentage points. This is the lowest since the 2020 pandemic recession.

The yield curve can’t tell us everything.

Some analysts and investors claim that the yield curve is over-focused as a popular recession signal.

One of the most common criticisms is that the yield curve tells us very little about when a recession will begin, and that a recession will probably occur. According to Deutsche Bank data, the average time to recession after a two-year yield exceeds a ten-year yield is 19 months. However, the range is 6 months to 4 years.

The economy and financial markets have also evolved since the 2008 financial crisis, when the model last became popular. The Fed’s repeated purchases of government and mortgage bonds to support financial markets have swelled the Fed’s balance sheet, with some analysts claiming that these purchases could distort the yield curve. ..

Both of these are points that Harvey accepts. The yield curve is an easy way to predict the growth trajectory and potential recession of the United States. Proven to be reliable, but not perfect.

He suggests using it in combination with research Chief Financial Officer’s Financial ExpectationsThey usually lower corporate spending as they become more worried about the economy.

He also pointed to the cost of borrowing a company as an indicator of the risks investors perceive in lending to private companies. These costs tend to rise as the economy slows. Both of these measures are currently talking about the same thing. Risks are rising and expectations for a slowdown are rising.

“If I go back to my summer internship, will I only see the yield curve? No,” Harvey said.

But that doesn’t mean it’s no longer a useful indicator.

“It helps. It’s very valuable,” Harvey said. “It’s a duty for managers of every company to take the yield curve as a negative signal and engage in risk management, and for people. Now, make the most of your credit card on expensive vacations. It’s not time. “