For the past 75 years, yield curve inversion—when short-term interest rates climb above long-term rates—has preceded the onset of every recession and has also provided advance warning of severe stock market falls associated with bear markets. An inversion typically occurs 11 months before economic contractions and approximately six months before stock market peaks.
Given this track record, it’s not surprising that the financial and popular press has jumped on the bandwagon and now routinely uses relative interest rate levels to predict an “imminent” or “inevitable” recession. However, much recent reporting has failed to take into account the economic reasoning underpinning the indicator’s predictive potential, and we believe the outcome is a faulty interpretation of the current recessionary probability in the United States. Let’s have a look at the 2022 inverted yield curve.
Not all curves are created equal
The gap between 10-year Treasury yields and 3-month borrowing rates hasn’t been mentioned in any of the recent commentary on yield curve flattening and inversion that we’ve seen. On the one hand, this isn’t surprising: the 10-year vs. 3-month yield isn’t close to inversion and has recently been steepening rather than flattening. At the same time, the Fed’s avoidance of the 10-year vs. 3-month difference is surprising: after all, that measure of yield curve steepness is used in most academic research on recession prediction and, not surprisingly, is the Fed’s favored yield curve measure.
Although the media has emphasized the recent inversion in the 2-year versus. A 10-year portion of the yield curve, the Fed’s concentration on 3-month vs. 10-year maturities has economic justification. Many firms’ capital structures include bank loans, which are often tied to short-term borrowing rates like the 3-month yield. The 10-year yield is a good indicator of market growth forecasts.
As 3-month rates reach beyond 10-year yields, we expect corporate leaders to postpone capital projects until growth projections improve, instead of using the funds to pay down short-term debt. This would likely limit overall economic growth, providing much-needed reasoning for how a flattening yield curve relates to the likelihood of a recession. When the news analyses flattening between other points on the yield curve, this connection is frequently missed or brushed over.
Incorporating future policy moves
One disadvantage of using the 3-month rate as the basis for curve assessment is that it takes a long time to adjust when the Fed signals a significant change in interest rate policy. As a result, when addressing inversion, many bond trading desks prefer to look at the 2-year vs. 10-year Treasury yield, believing that the 2-year better reflects market projections of where short-term interest rates are headed and thus provides an earlier indicator of a potential oncoming recession. One obvious flaw in this technique is the challenge of forecasting future Fed policy; after all, few, if any, bond market analysts forecasted monetary policy in the previous two years.
