Given the inherent risk of holding fixed income securities, investors expect to be compensated for locking up their money for longer periods of time, rather than simply rolling over shorter-term maturities. This incremental compensation is known at the term premium. Long-term yields equal long-run nominal growth expectations plus a term premium.
Yield curve inversions occur when shorter-dated securities offer higher yields than longer-dated securities. On its face, this would appear nonsensical because there is no obvious reward for tying up capital for longer period. But inversions do occur periodically, when Federal Reserve monetary policy trends toward restrictive and demand for longer-dated securities increases to such a degree that investors are obliged to accept a correspondingly lower yield. In most instances, these inversions are temporary aberrations and generate little excitement.
But not always. The financial media’s fixation on the shape of the Treasury curve heightened in early April, when the yield on the 2-year note exceeded the yield on the 10- year note. The difference wasn’t much—less than 10 basis points separated the yields on offer—but the “inversion” was enough to trigger a kerfuffle among market observers who wondered whether the event heralded an economic recession. A 2s/10s inversion has often been cited—and was again last week—as a reliable recession indicator, even if not a direct cause. This is true to a point, but the lag between the indicator and the actual event can be lengthy.
Recessions are almost always preceded by a flat or inverted yield curve. There have been numerous instances in the past where a flat or inverted yield curve has been followed by a recession. Theories abound as to the
reason for the correlation. The yield curve reflects investor expectations, so inversions may convey a widespread belief that the Fed will err by tightening monetary policy too abruptly. Investors may believe that parking money in longer bonds is a safer bet than committing capital elsewhere in the face of a tighter monetary regime. To the extent the Fed tightens too quickly, the cost of capital becomes greater than the return on capital, restricting lending and constraining economic activity.
We are unrepentant believers in the importance of the Treasury yield curve as a useful indicator of current investor sentiment, but not necessarily as an economic predictor. Investor preferences will determine the shape, and not all yield curve shapes are the same. We believe the spread between the 2-year and 10-year yield is less useful as a forward indicator of economic recession than the spread between the 3-month bill and the 10-year note. Shorter maturities, such as the 3-month bill, are more directly influenced by the overnight rates controlled by the Fed. The 2y/10y spread is often the highlighted spread in the popular press, but it is the 3m/10y which more accurately reflects banks’ net interest margins. And the yield on offer at three months is still far lower than the yield on a 10-year note. This suggests that the Fed has not yet tightened monetary policy to such a degree that it would constrain economic activity enough to trigger an economic recession.
Moreover, in today’s unique environment, inflation is forecasted to be substantially higher over the next few quarters due to supply chain bottlenecks and pandemic-related shutdowns in Asia. The outlook for longer-term inflation beyond 12 months is more restrained. Real yields are substantially more negative in the short end than over the longer term, so investors should not ignore the upward sloping real yield curve when assessing the near-term growth outlook.
Investors should not ignore trends within the shape of the yield curve. But neither should they panic over the recent media attention. The yield curve has been a useful forward indicator forecasting future recessions, but the 3m/10y spread is the better marker. Today's unique market influences are expediting an inversion in the shape of the 2y/10y yield curve more than fundamental indicators would suggest. We cannot rule out a deeper and more widespread yield curve inversion in the future if the Fed tightens materially above the neutral rate, but an imminent recession in the near term strikes us as unlikely.
Content is a product of the Chief Investment Office (CIO).
Main contributors: Leslie Falconio, Alina Golant, Barry McAlinden, Kathleen McNamara, Thomas McLoughlin
Read the full report - The shifting shape of the yield curve, 14 April, 2022.