The Latest Bad News About the Yield Curve

Although it isn’t a perfect predictor, it shouldn’t be ignored.

When it comes to economics and finance, it’s all too common for past patterns—specifically correlations like the one between yield curve inversions and impending recessions—to be taken as unbreakable natural laws. That could result in serious risks and strategic errors.

When the yield curve inverts, with interest rates on shorter-term bonds higher than those on longer-term bonds, a recession usually, though not always, occurs within a year or two. The “market” as a whole believes that the economy will slow down in the long run, which is why the Fed is cutting short-term rates to avoid a recession. Because they won’t get as much money from reinvesting when bonds mature because rates will be lower, they require higher interest rates on short-term bonds to make up the difference.

Although recent yield curve inversions have been observed, speculators have pointed out a number of potential confounding variables. Short-term Treasury bond rates have increased more quickly than longer-term ones as a result of high inflation and the Federal Reserve’s swift interest rate rises in response. The Russian invasion of Ukraine, rising discontent, and protests in nations like Iran and China are all examples of geopolitical turbulence that prompts investors to seek out safer places for their money, such as 10-year US Treasury bonds, driving up prices and returns down. These pressures, according to speculators, are pushing rates in opposite directions and causing an uncommon inversion type.

Be that as it may, markets are gatherings of people, and people have emotional reactions to things. Mechanical stresses coming from two directions that cause inversion and recession fears won’t just go away on their own.

For instance, analysts of this data could claim that there had not been an inversion between the three-month and ten-year bonds after conducting the research. That’s not the situation anymore. According to reports from the Federal Reserve Bank of St. Louis, the 3-month yield has been higher than the 10-year yield for weeks. The 3-month/10-year inversion has predicted a recession in 7 out of 9 recessions between 1957 and the Great Recession, according to Christopher Waller, who is currently a Fed governor but was the St. Louis Fed’s director of research at the time of this 2018 presentation.

What about the global economic crisis following the coronavirus outbreak? 2019 had an extended period of a 3-month/10-year inversion.According to Duane McAllister, senior portfolio manager at US firm Baird Advisors, consistent inversions like this one has been a fairly accurate predictor of impending recessions in the past.

If the Atlanta Fed’s early indicator is accurate and the annualized GDP growth for Q4 is actually 4.3%, economic growth appears to have returned. Despite high-tech layoffs, labor markets have remained strong. It doesn’t appear that the Fed is prepared to lower rates.

The signs might not be 100% accurate, but ignoring them could be dangerous.

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