Forget political squabbles, investors look at Treasury yields and see bad omens
While politicians debate whether the United States is in a recession, a metric closely tracked by investors on Wall Street and beyond suggests the economy could weaken in the coming weeks and months.
The Treasury yield curve is regarded as one of the reliable indicators of a recession, and investors are watching out for an inverted yield curve, which takes place when short-term rates for Treasury notes are higher than long-term rates.
Investors who put their money in a 10-year Treasury instrument instead of a two-year note may be indicating they do not have confidence in the economy’s overall health.
The Federal Reserve has raised interest rates by 225 basis points to fight inflation this year, sending the yield on the two-year Treasury note almost 50 basis points above that of the 10-year note.
That is the deepest inversion since 2000. The inversion retreated to 40 basis points from 50 on Wednesday after softer-than-expected inflation data for July, Jamie McGeever, a capital markets columnist for Reuters, said on Wednesday.
Inversions happen when investors sell stocks and shift their cash to bonds. Their thinking is that smaller, guaranteed returns from bonds might exceed what they could lose by owning stocks going into a recession. Higher demand for bonds results in lower yields.
“This widespread loss of confidence explains why inverted yield curves have preceded every recession since 1956,” according to the CNBC network.
The last inversion began in December 2005 and preceded the recession that officially began in December 2007, followed by the 2008 global financial crisis. There was also an inversion in yields before the tech bubble burst in 2001.
On March 31, the two-year and 10-year yields inverted for the first time since 2019.
Recessions do not begin right after an inversion. Historically, an inversion tends to precede the recession by an average of six to 18 months.
Inflation is at a four-decade high. While the consumer price index ebbed in July, registering an 8.5 percent increase year-on-year, US equity markets have this year had their worst six-month start since 1970.
However, the lower rise in inflation, announced on Wednesday, did spark a rally in the stock market, with the tech-focused Nasdaq reentering bull market territory.
“The only reason why we are seeing this rally is because of the decline in oil, and that is not a good enough reason,” Vladimir Signorelli, head of Bretton Woods Research in New Jersey, told Forbes.
The downward-sloping yield curve will also erode margins and curb bank lending. The economic impact of banks reducing credit to businesses and households is a negative development.
“The slope of the curve matters,” said Christopher Wolfe, managing director of North American Banks at Fitch Ratings in New York.
The Fed’s latest Senior Loan Officer survey shows that a “significant” net 24 percent of banks tightened lending standards for commercial and industrial loans in July.
Morgan Stanley’s Betsy Graseck estimates that the three largest US banks, JP Morgan, Bank of America and Citi, may need to reduce their riskiest assets by more than $150 billion by the end of this year.
As for the debate about whether the US economy is already in recession, gross domestic product growth was negative in the first and second quarters of this year, a development that meets the traditional definition of a recession.
But many economists say a hot jobs market, with average growth in employment this year running at almost 500,000 a month, will lead the National Bureau of Economic Research to refrain from calling the current situation a recession.
Peter Earle, a research fellow at the American Institute for Economic Research, said the most surprising aspect of the jobs market is that “the number of Americans not only working two jobs, but two full-time jobs, reached a record high”.
Mauro Forlin, an asset manager for financial media group Money-Web, said in a column on Wednesday that some economic signals could be recessionary. He notes that the ISM Manufacturing New Orders Index has been in contraction since June. That signals that some companies are beginning to see a slowdown in new orders and demand.
Agencies contributed to this story.