The U.S. Treasury market is nearing a key threshold that usually heralds a recession. The question for policy-makers is whether this traditionally reliable indicator might be broken following a barrage of stimulus measures.
Treasury yields are closing in on a so-called curve inversion, where long-term borrowing costs fall below those for shorter tenors. This market flip, which has preceded every recession in the last 50 years, is traditionally driven by investor pessimism about short-term growth prospects and expectations for an eventual economic recovery.
This time the signal is hard to read because long-term yields have been driven down by nearly two years of $120 billion monthly Federal Reserve bond purchases that helped nurse the economy through coronavirus disruptions. The Fed has also kept rates close to zero — a sharp contrast to previous inversions, which happened with benchmark rates averaging 5.7% and more than five years after the curve flattened out, according to Ross Mayfield, an investment strategy analyst at Baird.
Fed bond-buying "lowers the reliability of the yield curve as an indicator" of recession risk, said Antoine Bouvet, a senior rates strategist with ING. Furthermore, "the shape of the curve should always be taken with a pinch of salt because every cycle is a bit different," he said.
An inversion will likely happen before year-end, helped by four Fed rate hikes from March to July, according to Steve Englander and John Davies of Standard Chartered. The rate hikes, totaling 100 basis points, will leave the yield curve "completely flat" by mid-year, the strategists wrote in a Jan. 28 note.
At present, five-year Treasuries are yielding just 49 basis points less than 30-year debt, the least since January 2019. The two-year, 10-year gap is at 63 basis points, the lowest since October 2020.
"The curve is currently too flat," said Gennadiy Goldberg, a senior rates strategist at TD Securities. It is "much flatter than it typically is going into a hiking cycle," he said.
Fed Chairman Jerome Powell has said the risk of yield inversion is "one of many things" that policy-makers monitor. Still, he sought to allay concerns that a recession was inevitable if it does happen.
"I don't think of it as some kind of an iron law," he said during a Jan. 26 press conference. "But we do look at it and try to understand the implications and what it's telling us."
The Fed could try to prevent a yield inversion by slowing the pace of rate hikes, said John Canavan, a lead analyst with Oxford Economics. Policy-makers could also support longer yields by accelerating a planned reduction in the Fed’s $9 trillion balance sheet, he said.
Esther George, president of the Federal Reserve Bank of Kansas City, has advocated faster balance-sheet reduction as a way of lowering the number of potential rate hikes.
Still, on-going market volatility and the risk of new flare-ups in the global pandemic mean that it is hard to predict what will happen to rates this year, said Goldberg with TD Securities. Those concerns also make it difficult to forecast and interpret a curve inversion.
"There is an incredible amount of uncertainty about where rates are going in the future and we're still in the early days of the rate hiking cycle," Goldberg said. "Markets could still very much reprice."