What is the yield curve and how could it warn of the next recession?

NEW YORK (AP) — One of the most reliable warning signals of an economic recession has started flashing again.

The “yield curve” is watched for clues about the bond market’s view of the long-term outlook for the US economy. On Tuesday, a heavily watched part of the yield curve briefly brightened for the second time this year.

What is the yield curve?

At the center of the investment world are treasury bills, IOUs that the US government issues to investors who lend it money. The yield curve is a graph showing how much interest different treasury bonds pay.

At one end are shorter-term treasury bills, which are repaid in months or years. At the other end of the chart are longer-term Treasuries, which take 10 years or decades to mature. Short-term yields closely track expectations of what the Federal Reserve will do with overnight interest rates, while long-term yields move more in line with expectations for economic growth and inflation further ahead. long term.

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Usually, longer-term Treasuries offer higher yields than short-term ones, resulting in a chart with an upward sloping line. That’s partly because investors generally demand higher yields to tie up their money longer, given the possibility of future rate hikes by the Fed and the risk of inflation. But when investors worry about a sharp downturn, perhaps because the Fed is pushing short-term rates too high too quickly, they are willing to accept less for a Treasury maturing many years in the future.

When yields on short-term Treasury bills are higher than those on long-term Treasury bills, market observers call it an “inverted yield curve.” And when that chart shows a descending line, Wall Street starts to get nervous.

Why care?

All the talk about charts and returns is hard to digest. An inversion of the yield curve is considered a reliable predictor of a recession, although it has sometimes inverted without a recession following.

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Some market watchers, including Federal Reserve officials, consider the relationship between 3-month and 10-year Treasuries to be more important. Every recession in the past 60 years has been preceded by an inversion of the yield curve between three-month and 10-year Treasury bills.

There is usually a lag between the two. A rule of thumb says it takes about a year after the three-month Treasury yield rises above the 10-year yield before a recession begins, according to the Federal Reserve Bank of Cleveland.

What happens now?

At 1.75%, the three-month yield is still well below the 10-year yield of 3.48%, so no reversal here.

But on Tuesday, the two-year Treasury yield briefly rose above the 10-year yield, before falling back below to 3.42%. The two yields reversed previously in early April. Other less followed parts of the yield curve are also already inverted. Although they are less consistent in predicting recessions than the three-month yield versus the 10-year yield, they show that the trend is moving towards pessimism.

After a reversal in 2019, the global economy plunged into recession in less than a year. At that time, however, the bond market did not see the pandemic coming. It focused on global trade tensions and slowing growth.

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Now the two-year yield is soaring as investors believe the Fed will act more aggressively. The central bank has already pulled its overnight rate to a record low in an attempt to combat high inflation and is preparing to raise rates several more times by larger amounts than usual.

A Friday report that showed inflation getting worse bolstered expectations among many investors that the Fed will raise overnight rates by double or even triple the usual amount at its next meeting.

The two-year yield has more than quadrupled in 2022 alone. The 10-year yield has also increased, but not as rapidly.

So the yield curve simply reflects bond market thinking?

It could also have real effects on the economy. Banks, for example, make money by borrowing money at short-term rates and lending at longer-term rates. When this spread is large, they make more profit.

An inverted yield curve complicates this, however. If this causes banks to cut lending – and therefore growth opportunities for businesses – it could help tighten the brakes on the economy.

Is it a perfect predictor?

No, an inverted yield curve has sent false positives before. Three-month and 10-year yields reversed in late 1966, for example, and a recession didn’t hit until late 1969.

Some market watchers have also suggested that the yield curve is now less important because herculean measures by global central banks have distorted yields. During the pandemic, the Federal Reserve bought trillions of dollars in bonds to keep long-term yields low, after cutting overnight rates to near zero. It has recently started to allow some of these bonds off its balance sheet, which should add upward pressure on long-term yields.

Should I panic?

Fed Chairman Jerome Powell would say no. Earlier this year, he said he paid more attention to the first 18 months of the yield curve than to what happens between the two-year and 10-year yields.

“It has 100% of the explanatory power of the yield curve,” he said, and it’s not reversed.

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And while two-year and 10-year Treasury yields have reversed twice this year, they may just be temporary hiccups rather than a lasting trend.

Many investors, however, worry about a recession or the possibility of “stagflation,” which would be the painful combination of high unemployment and high inflation.

The bond market, of course, also looks more pessimistic. Just look at the yield curve.

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