Historical moves in the Treasury signal high inflation, but perhaps not a recession anytime soon
The shape of the Treasury yield curve may be the biggest recession warning in nearly 42 years, but some strategists say it may actually reflect high inflation, rather than a pending economic slowdown. An inverted yield curve is considered a harbinger of recession, and the already inverted yield curve stretched even wider this week to its most inverted level since 1981. The yield curve is inverted when short-term interest rates rise above longer-term interest rates, as in the case of the 2-year Treasury rate and the 1[ads1]0-year yield. At one point Wednesday, the 2- to 10-year spread was negative by as much as 111 basis points Wednesday, the widest it has been since September 1981. One basis point equals 0.01 percentage point. “Curves like the 2s10s in Treasuries crossed the psychological level of -100bps and while there is no economic significance to -99bps vs -100bps, optically it has more of a ‘recession pricing’ look,” wrote Jan Nevruzi of NatWest Markets. 10Y2YS 1Y Line Inversion Recession or a sign of inflation? Wall Street strategists and economists have disagreed about whether the curve inversion has actually predicted an economic contraction and, if so, when that recession might begin. “The [inversion] means that we are facing much higher inflation than expected and the fact that the Fed will have to move to a much higher terminal rate than previously hoped for,” said Andrzej Skiba, head of US fixed income at RBC Global Asset Management. the US economy. The current shape of the yield curve tells you more about sticky inflation.” Comments from Federal Reserve Chairman Jerome Powell this week triggered the move wider in the spread. He told Congress that the Fed may have to raise interest rates to higher-than-expected levels due to inflation.. The short end of the curve, or the 2-year yield, was at 5.06% on Wednesday afternoon, while the 10-year gave just under 4%, at 3.98%. The 10-year yield is more reflective of the outlook for economic growth.”[The inverted curve] historically it was a harbinger of recession coming further down, but in our view that doesn’t automatically mean that any hope of a soft landing scenario is gone,” Skiba said. He said his forecast includes recession, but there has been an increasing chance of that the U.S. can avoid a period of negative growth because of the strength of the economic data, he said.Skiba also said that the higher interest rates have not had as much of an impact on the consumer as they could because of both the strength of the labor market and the fact that many homeowners locked into low-interest mortgages before interest rates started to rise. “Yes, in historical terms with this type of inversion, it’s reasonable to expect recession down the line, but we’re not saying it’s a given that this curve means that a recession is coming over the coming quarters, because both the US economy and the consumer are in much better shape and entering a potential downturn than expected,” Skiba said. That makes all of the incoming economic data more important , including Friday’s February employment report and the March 14 consumer price index, he added. Looking for an inversion reversal Jonathan Golub, chief U.S. equity strategist at Credit Suisse, said the curve could be warning of a recession, but the futures market indicates it may not be until January 2026, when futures show the curve coming out of its inverted state . Golub said the outcome of the inverted curve recession forecast has been different in periods of high inflation versus low inflation. The inflationary years of the 1970s and 1980s were different from those of the 1990s and later. For example, he said that when inflation was high, recessions began on average five months before the curve inversion ended, while recessions come more quickly when inflation is low. During periods of low inflation, recessions came on average five months before the inversions ended. “Over the past 50 years (excluding the pandemic period), the curve has inverted 6 times, with recessions after 11 months on average, with no false positive or negative indications. With the yield curve inverted since last October, it is no surprise that bearish pundits are predicting a economic downturn,” Golub said in a note. “Using the period of high inflation as a guide, futures point to a recession in August 2025, about 2½ years from now.” Golub said in a telephone interview that the arrival of a recession is the logical outcome. “It’s not the curve reversal that’s the problem. It’s the reversal of it,” he said. “What happens here is you have inflation and the Fed tightens interest rates. They start raising interest rates. The market starts anticipating a recession, so the 10-year bond yield is lower, and the 2-year is higher because it fights inflation. The long and short interest rates are linked to different signals.” When the economy begins to weaken, the Fed removes some of the tightening, and short-term interest rates begin to fall. “The curve is deflating because the Fed is seeing a recession, and they’re reacting to it,” Golub said. “You could argue that, too [the reason] it takes longer for the curve to deflate in a high-inflation environment because the Fed is forced to become more draconian in its actions when inflation is high.” It’s not surprising that some on Wall Street see a recession coming sooner. “Why are people predicting recession sooner rather than later? Recession indicator No. 1 is the steepness of the yield curve. They’re using an old playbook, after the last three recessions and how long after the Fed’s pause,” he said. “If you look at the last three recessions, we should be entering this recession soon.”
