Since 2022, under the guidance of the expectation of accelerated monetary policy tightening by the Federal Reserve, the YIELD of US treasuries has risen sharply, and the short end has a greater upward range, the curve shape is obviously flat, and some key term interest rates have inverted. As of April 8th close, (10Y-3Y), (10Y-5Y), (10Y-7Y) maturity spreads were -1bp, -4bps, -7bps, respectively. In addition, the closely watched (10Y-2Y) maturity spread also reversed to -5bps on April 1, sparking fears of a US recession.
The inverted YIELD curve raises recession fears
The inverse of the two-year yield to the 10-year yield is often seen as a forward-looking sign of a recession. Historically, there have been seven inverted yield curves in US history since 1980. According to the Definition of the National Bureau of Economic Research (NBER), except 1998, all the other six reversals successfully predicted the RECESSION in the United States, and the interval between the first inversion and the recession is usually 1-2 years. 2019 was a special year, as the coronavirus outbreak triggered an early recession, reducing the time between downturns to six months.
Figure 1: Us Bond yields substantially flatten to the upside
Data source: Wind
Figure 2: Reversals and declines since 1980
Data source: NBER, Wind. Note: The gray areas are the decline periods defined by NBER
Although the most widely used, the (10Y-2Y) term spread is not the only indicator of a US recession. Recently, colin Powell, chairman of the federal reserve in the national association for business economics (NABE) speech mentioned that the federal reserve in the research of the yield curve inverted and recession risk focus more on short-term yield curve, when the federal reserve has in many working papers have studied different time limit the effectiveness of the carry on the forecast of economic recession, the most common are the following two term spreads.
One is the (10Y-3m) term spread. In addition to the (10Y-2Y) term spread, the (10Y-3m) term spread is also widely watched by market players and the Federal Reserve and is used in the New York Fed recession model. The San Francisco Fed has argued that the (10Y-3m) term spread is the strongest predictor of upcoming recessions among yield curves. Three-month Treasury yields are highly correlated with the federal funds effective rate, reflecting the expected level of the three-month policy rate. In past downturns, (10Y-3m) has been accompanied by (10Y-2Y) reversals.
The second is near end forward spreads. Research by Fed economists Engstrom and Sharpe in 2018 and 2019 showed that the near-term forward spread, The difference between 3-month forward and 3-month spot yields 18 months later) is a better predictor of recessions because it better represents the expected path of policy in the short term, similar to the policy rate expectations implied in the fed funds futures market. In contrast, the 10-year Treasury yield contains more noise, such as inflation risk premium, liquidity premium, Fed asset purchases, etc., making the (10Y-2Y) maturity spread difficult to reflect purely the expected path of future short-term rates.
As of April 8, the (10Y-3m) maturity spread has widened 52BPs from the end of last year to 202BPs, and the same near-end forward spread has continued to widen. According to the latest data from the New York Fed, the near forward spread has widened by 111BPs to 220BPs since the end of 2021 as of March 18. The spread between (10Y-3m) term spreads and the near forwards has continued to widen, diverging markedly from the continued narrowing of (10Y-2Y) term spreads.
The difference of this inverted yield curve
Divergence between maturity spreads has been rare in past rounds of curve reversals, suggesting there may be something special about this one.
(I) This round of inverted curve occurs in the early period of interest rate hike cycle
Past episodes of curve reversals occurred late in the rate-raising cycle, after which the Fed often stopped raising rates or even entered a rate-cutting cycle. In the later stages of a rate hike, if the market expects a possible recession ahead, the 2-year yield, which implicitly expects a rate cut, will be lower than the 3-month yield. Therefore, if the (10Y-2Y) spread is inverted, the (2Y-3m) term spread and the near-end forward spread will simultaneously narrow or even invert, and there will be no divergence between the term spread indicators.
The curve inversion, which followed the Fed’s first rate hike in March, suggests the central bank has fallen behind the economic cycle in its policy actions and has had to tighten faster to contain surging inflation. Fed officials expect seven rate hikes this year, with the median forecast for the benchmark rate reaching around 1.9 percent by the end of 2022 and rising to around 2.8 percent by the end of 2023, according to a dot plot released at the Fed’s March meeting. Because the rate hike path of the next two years is very steep, lead to two-year Treasury yields rise sharply, the three-month yields because time is too short, only in 1 to 2 times to raise interest rates, so the current (2-3 m y) term spreads widened sharply, similarly also triggers the proximal forward spreads widened, result in different period carry index of deviation.
(b) The real yield curve is still steep
Historical experience suggests that real interest rates usually move inversely with nominal rates before recessions. Since the 2-year TIPS yield data goes back as far as October 2004, it can be observed that real interest rates were inverted along with nominal rates before the two recessions after 2005.
The real yield curve, using TIPS as a representative of real interest rates, remains steep, with the spread (10Y-2Y) widening 26BPs from the end of 2021 to 163BPs as of April 8. The reason is that short-term inflation expectations are significantly higher than long-term ones. As of April 8, market inflation expectations, as measured by the break-even rate of inflation, were as high as 5.74% over the next one year, 4.32% over two years and just 2.88% over 10 years. The market expects that the supply chain disturbance caused by the epidemic and russia-Ukraine conflict is only a short-term factor. In the future, with the lifting of supply-side constraints, weakening fiscal stimulus and tightening of monetary policy, inflation pressure is expected to return to the normal level in the long run. Therefore, the current negative nominal interest rate spread (10y-2Y) as a forward-looking measure of recession is somewhat distorted.
(c) An inverted curve does not necessarily lead to a recession
The current inverted US Treasury yield curve faces a completely different macro environment and policy response mechanism from the past rounds, which weakens the effectiveness of the single maturity spread indicator in predicting the US economic outlook.
When COVID-19 broke out in 2020, the US government introduced ultra-loose monetary policy and large-scale fiscal stimulus to support the US economy. At the same time, the Federal Reserve adjusted the framework of monetary policy implementation into “Average Inflation Targets (AIT)”, allowing the Inflation level to exceed the 2% target for a period of time to compensate for the impact of earlier Inflation below 2%. The rationale for this change is that the Phillips curve has flattened since the 1980s, reflecting a long-term trend of strong labor markets but persistently low inflation, so the Fed does not believe that an overheated labor market will necessarily lead to runaway inflation. However, the important reason why the Phillips curve has been dormant for a long time is precisely that in the past, the Fed’s monetary policy has anchored the market’s inflation expectations well, and deviation from this goal may cause the Phillips curve to steepen again.
Under the influence of multiple factors, such as the slow repair of global supply chains caused by the epidemic, the rebound of demand stimulated by monetary and fiscal easing, and the rise of inflation expectations caused by the new monetary policy framework of the Federal Reserve, the Phillips curve has been reawakened, and the INFLATIONARY pressure in the US has skyrocketed, and there is a risk that inflation expectations will be unanchored. The US unemployment rate has fallen to 3.5 per cent and is at full employment, while the CPI rose 7.9 per cent year-on-year in February, the biggest year-on-year increase in 40 years. The five-year and 10-year break-even inflation rates, which measure the market’s inflation expectations, peaked at 3.57% and 2.92% in March 2022, indicating that the market’s inflation expectations are no longer anchored to the 2% policy target, and the US economy is facing certain medium and long-term inflation risks.
Figure 5: After 2005, real interest rates were usually accompanied by an inversion of nominal interest rates
Source: Bloomberg. Note: The gray areas are the decline periods defined by NBER.
Figure 6: The Treasury TIPS yield curve steepens
Data source: Wind
It is clear that the Fed’s new monetary policy framework did not adapt well to the post-pandemic macro environment, leading the Fed to clearly underestimate inflationary pressures, and the US economy was already overheating with a strong recovery in the Labour market. In a high-inflation environment, the current inverted yield curve reflects more the Fed’s policy tightening lagging the economic cycle than market trading pricing in a recession.
In effect, the Fed can regulate the shape of the yield curve directly through its balance sheet tools. If necessary, as the recession is expected to reverse the financial markets, the federal reserve could by speeding up table speed reduction or adjust the structure of the duration of the assets held, such as speed up the sale of long term assets or slow to sell short term assets, pushing up long term of the interest rate premium, guide (10 y – 2 y) term spreads widened, make curve to steep.
Therefore, the relationship between the inverted US bond yield curve and economic recession should be viewed dialectically. The inverted US bond yield curve does not necessarily lead to economic recession, and the US economy may gradually step from the overheating stage to the slowdown stage if the curve remains steep. Medium to long term, because the helpless, the federal reserve to supply bottlenecks can tame inflation through inhibition of aggregate demand, and in the epidemic situation is unclear, the conflict between Russia and Ukraine to reshape the backdrop of the global energy structure, global inflation pressure is difficult to rapid relief, or the federal reserve will be more economic cost to control inflation, economic slowdown or even recession still exists, the possibility of However, it remains to be further verified by subsequent economic data.
In conclusion, it is more important to observe changes in economic fundamentals when term spread indicators are less effective, and changes in economic indicators such as tightening credit conditions, rising unemployment rate and declining capital expenditure of enterprises may be more practical as forward-looking signals of recession.
