Is a US recession imminent? That may be for the National Bureau of Economic Research (NBER), the official body tracking the US recession, to formally announce it, but markets are hooked to an indicator known as the inverted yield curve.
The yield curve ‘inverts’ when short-term yields exceed long-term rates, which occurs when the yield on a two-year Treasury bond exceeds the yield on a 10-year Treasury bond. Rather, the 2-year yield should be lower than long term rates.
In the past, an inverted yield curve signalled the beginning of a recession. In fact, every recession since 1956 has been preceded by an inverted yield curve. When the two-year and 10-year Treasury yield curves invert, there is a more than 67% chance that the United States will enter a recession within 12 months and a more than 98% chance that a recession will occur within the following two years. This was established by Bespoke’s research platform.
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An inverted yield curve indicates that credit conditions are becoming tighter. Because banks tend to borrow in short-term markets and lend in longer-term markets, the Fed’s policy tightening boosts the cost of borrowing for individuals and businesses as banks pass on increased charges and reduce lending. These trends are reflected in the Federal Reserve’s recent poll of bank senior loan officers, which revealed that banks are less ready to lend and that loan demand is declining.
The yield curve is currently inverted at 3.98% in two years, 3.45% in 10 years and at about 3.70% for the 2053 maturity.
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For quite some time, the yield curve has been signalling that rates have peaked and that recession risk is increasing. More than a year ago, the yield differential between two-year and 10-year Treasuries fell into negative territory. Following a brief uptick, the yield curve has been inverted (long-term rates are lower than short-term yields) for more than nine months.
The most recent manufacturing data has been lacklustre, and consumer spending has been dropping. Inflation remains significantly above the Fed’s long-term target of 2%, raising the possibility of another 25 basis point (0.25%) rate hike at the Federal Open Market Committee (FOMC) meeting on May 2-3. However, with the possibility of a credit crunch and recession increasing, it is widely believed this will be the cycle’s final rate hike.
The case for a recession rests on how severe the credit crunch is and how fast the Fed is able to bring the short-term rates lower for the yield curve to un-invert. An inverted Treasury yield curve has a significant impact on markets and the economy as a whole. Inflation is cooling down but taming it could just be a half-done job for the central bank. Before calling it a day, the Fed must do the right thing and un-invert the yield curve. The economy should not suffer if inflation is defeated.