Yield Curve: Meaning of Inversion
The yield on two-year Treasurys exceeded that on the 10-year three separate times last week. The phenomenon, known as “yield curve inversion,” occurred for the first time on Tuesday lasting less than a minute, and recurred on Thursday. On both days, the yield curve ended being slightly positively sloped. It was not until Friday that the curve inverted convincingly — ending the day with the yield spread at negative 8 basis points. The spread had narrowed by a significant 12 bp during the last trading day of the week. By comparison, the yield spread had been 80 bp at the start of 2022.
Inversion of the the yield curve is closely followed as a precursor of recession. Why is it an important indicator, and why did we have to wait until Friday for the curve to be inverted through the close of trading?
The yield on 10-year Treasurys is normally well above that on the two-year because of the longer time period that the funds are lent for. On the other hand, when investors fear a recession, they are willing to lock the yield for a longer period of time in a safe-haven security, pushing the long-term yield lower than the short-dated paper.
A second reason is that the two-year Treasury yield is considered to be the best leading indicator of Federal Reserve policy. When this yield goes above that on 10-year Treasurys, the move would suggest that bond investors believe that the central bank is going to raise rates so high as to push the economy into recession.
For example, the 2 - 10 yield curve inverted several times during 2006 in a sustained fashion, i.e., lasting several days. While equity investors toasted what they believed was a robust economy by pushing the S&P 500 index to a record high in October 2007, the Great Recession began a couple of months later. The bond market had anticipated the recession more than a year earlier. The equity market just did not.
A third reason for the significance of the shape of the yield curve comes from the financial sector. Banks depend on a positively sloped yield curve for their earnings — to be able to borrow short-term at a low interest rate and to lend long-term receiving a higher interest rate. When this is reversed, the lenders would be better off not lending — and that would hurt economic growth.
The persistence of curve inversion on Friday is traceable to the strong job numbers released by the Bureau of Labor Statistics that morning. The US economy created 431,000 jobs in March but with the annual growth in average hourly earnings accelerating from 5.2% in February to 5.6%. This ended any doubt in bond investors’ minds that the central bank would raise rates several times, even by 50 bp on occasion, in its efforts to lower both wage and price inflation.
However, neither the persistent supply bottlenecks — not from covid this time, but as a fallout from the Russia - Ukraine conflict — nor the surging price of energy will respond to Federal Reserve policy. The developments are changes in the global economic structure. What higher interest rates would do instead, the Treasury bond market reasoned, is push the economy into recession.
What about Fed Chairman Jerome Powell’s assertion on March 16 that “the probability of a recession within the next year is not particularly elevated”? Responding to a journalist’s question, Powell justified his stance noting that “aggregate demand is currently strong” and “the labor market [is] also very strong.”
Economists who have witnessed several business cycles know that it is hazardous to extrapolate simply based on the current state of the economy. It is easy for an individual at the edge a precipice to have an illusion of being on top of the world!
Dr. Komal Sri-Kumar
President
Sri-Kumar Global Strategies, Inc.
Santa Monica, California
srikumar@srikumarglobal.com
@SriKGlobal
April 2, 2022
Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities. Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.
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