When the interest rate (yield) on shorter-dated government bonds rises above those of longer-term treasuries, many people in finance get the willies.
This phenomenon is known as an inverted yield curve, coming from the usual shape of the graph showing how yields on bonds from a certain issuer normally move upwards as the maturity of the bonds increase.
When the yield curve on government bonds flatten and then invert, this has often in the past been a red flag for a coming recession.
Last night on the bond market, the yield curve between 2yr and 10yr US Treasuries inverted for the first time since 2019.
This has arisen as investors are pricing in aggressive interest rate increases by the US Federal Reserve as it battles the effect of inflation that has reached its highest levels since the early 1980s and proved not as temporary as first supposed.
Jim Reid, a senior credit strategist at Deutsche Bank, noted the curve only dipped its toes into negative territory before re-steepening later in the US session.
“Nevertheless, the headline damage was done,” he acknowledged. “The momentum has been toward flatter curves for a while, so this moment has felt inevitable even if it happened quicker than we expected.”
Now that the inversion that everyone’s been waiting for has happened, “can we look at the curve steepening again?” wondered Neil Wilson at Markets.com, who also noted that the yield curve between 5yr and 30yr government bonds also inverted this week for the first time since 2006.
He said an inverted yield curve “is usually a pretty good recession indicator for the US; in 50 years it’s never missed. Typically, it takes about 18 months to come good.”
But at UBS, strategist Bhanu Baweja, said faster rate hikes by the Fed were likely to deliver “a short, sharp blow to returns, though still not creating a recession”.
Adrian Lowery, analyst at Bestinvest, said current economic and policy circumstances might mean that a recession is not necessarily around the corner.
“First, the inversion was brief and very narrow - it will be closely watched to see what happens in the coming days. Bond prices and yields, like other financial assets, are seeing big swings on a daily basis at the moment given the continually evolving news.
“Second, the other important spread between the yield on three-month Treasury bills and 10-year bonds has been widening this month, and is a long way from zero at 184 basis points, which does not suggest a recession is imminent.
“Third, the Treasury yield curve has, some analysts argue, been distorted by quantitative easing: the Fed's massive bond purchases are holding down long-dated yields relative to shorter-dated ones.”
As Baweja and Lowery said, the complex range of circumstances from Ukraine, high levels of liquidity in the global system, economies re-emerging from lockdown and through supply bottlenecks, and resurgent inflation, could play havoc with the supposed rules of the global economy.
“The inversion might signal for instance that investors believe inflation will stabilise in the long term, allowing rates to remain low – rather than rate cuts enforced by recession,” said Lowery.
And UBS’s Baweja said “we remain buyers of equities over the coming three to six months” but beyond this period was harder to tell, though the prediction is that “earnings are likely to stall amidst still tightening liquidity, increasing risks for the market”.