Investors who foresee a recession because of the yield curve’s recent inversion might be looking at the bond-market indicator all wrong.
That’s because although an inversion in some measures of the yield curve, such as the 3-month/10-year spread, might point to an economic downturn, other segments of that curve suggest a more optimistic view of the U.S.’s growth prospects.
These market participants point out that the widely watched 2-year/10-year gap has yet to turn negative, suggesting bond investors expect the U.S. central bank to embark on preemptive rate cuts to keep the economic expansion on track.
“While the short end of the yield curve has inverted for several weeks, the 2/10 year Treasury yield spread has widened a touch, an indication, I believe, that markets believe that we are not near a recession and that a near term rate cut or two will insure continuation of our expansion,” wrote James Meyer, a portfolio manager at Tower Bridge Advisors, in a research note.
The spread between the 2-year/10-year stands at a positive 24 basis points, from a recent low of 14 basis points in May 28, Tradeweb data show. The curve along this measure didn’t invert, but that fact was swiftly overlooked after the 3-month/10-year spread turned negative. Bond prices move in the opposite direction of yields.
Stocks and long-term bond yields slumped after President Donald Trump imposed tariffs against China in late May, re-opening a dispute that investors had hoped would reach a rapid resolution this year.
As a result, the benchmark 10-year note yield
pushed below its 3-month counterpart
in late May, and now trades at a negative 12 basis points. The S&P 500
also retreated from its all-time high set in April 30, but currently stands at around 2% from that peak, FactSet data show.
But investors say the 3-month bill yield’s relative higher level over other short-dated maturities created a misleading kink in the very short-end of the yield curve, and that once investors looked beyond the 2-year note, the slope of the curve was much steeper.
A steeper, or positive shaped, curve is often associated with expectations of economic growth and inflation. Longer-term maturities are more vulnerable to price pressures, so inflation can push their yields higher than their short-term peers. On the other hand, a flat curve or an outright inversion can indicate when monetary policy and financial conditions are viewed as too tight.
“I would not get very bearish on the economy. When we see this inversion, the only part that is mostly inverted is the 3-month bill. The yield curve is positively sloped after that,” Thanos Bardas, the co-head of investment-grade at Neuberger Berman, told MarketWatch.
Bardas said the U.S. central bank would embark on “insurance” cuts this year, giving a reprieve to markets rattled by the global economy’s weakness in the face of the U.S.’s trade war with China. That’s a view increasingly shared by traders in the fed fund futures market who now anticipate an 80% chance of a rate cut at July’s meeting by the Federal Open Market Committee.
Still, many say the gap between the 3-month and 10-year yield is one to watch.
Market participants point to its impressive track record as every time this spread has inverted, a recession has followed in the last nine economic downturns. It is also employed in the Federal Reserve’s gauge of recession probabilities, which currently points to a 30% chance of a recession by May 2020.
Fears of an economic downturn gained impetus after the May employment report showed the pace of job gains in the U.S. had slowed, suggesting nascent cracks in the ultra-tight labor market.