Hawkish comments from Federal Reserve Chairman Jerome Powell on efforts to tame inflation have deepened the inversion of the bond yield curve for US Treasuries, which many on Wall Street see as a leading indicator of a coming recession.
Powell delivered the Fed’s semiannual update to Congress monetary policy this week and told lawmakers the central bank would need to raise interest rates higher than previously expected because inflation remained stubbornly high despite a series of rate hikes amid strong economic growth.
One of the most closely watched spreads on the yield curve is the one between two-year and 10-year Treasuries, referred to as the “2/10 spread” as shorthand. The 2/10 spread has been reversed in July 2022 – just four months after the Fed began raising rates last March.
The 2/10 spread hit a negative 103.1 basis points on Tuesday – the biggest reversal between these securities since September 1981, when the economy was in recession as the Fed raised interest rates to curb runaway inflation – and widened to about 107 basis points on Wednesday.
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For context, the 2/10 spread has averaged about 84 basis points over the past few decades. The 2/10 spread was at its steepest in March 2010, when it reached 280 basis points, as the economy began to slowly recover from the financial crisis. The deepest inversion of the 2/10 yield curve occurred in March 1980 when it reached negative 199 basis points.
Paul Faust, the co-head of strategic accounts at BondCliQ, said FOX Business“The current inversion of the US Treasury curve signals the market’s concern about near-term inflationary pressures and the need for Fed action combined with its concern about a recession or a lack of long-term economic expansion.”
Powell said the Fed has not yet made a decision on the size of the next round of rate hikes to be announced after the central bank’s meeting in March. The Fed has eased the pace of rate hikes since its last two meetings, opting for a 25 basis point hike at its February meeting, which raised the benchmark federal funds rate to a range of 4.5% to 4.75%. This followed a 50 basis point increase in December, which had been preceded by four consecutive 75 basis point increases.
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Rising interest rates on Treasurys mean that interest rates on auto loans, credit cards and mortgages will also tend to rise, raising costs for borrowers and consumers. They also create an incentive for investors to move out of equity markets and into bonds, as they offer more attractive interest rates.
“Investors have historically compared 10-year bond yields to the S&P dividend yield when making investment decisions,” Faust said. “The S&P’s dividend yield is still near historic lows at about 1.3% versus 10-year yields of nearly 4%, a 15-year high. Given the recessionary concerns highlighted by the Treasury market, the equity market appears to be the risk more than a correction.”
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Yield curves and their relation to recession
Typically, long-term funds they carry higher interest rates than short-term securities because there is more uncertainty about the economy over a longer period of time, so bonds maturing 10 or more years into the future carry a risk premium in the form of higher interest rates. This means that typically, the yield curve slopes gradually upwards along the duration of a given Treasury security.
Yield curve inversions occur rarely, but are seen as a predictor of an upcoming recession because they suggest that investors believe that economic growth will slow in the short term and that over a more extended period of time, the Fed should return to cutting interest rates for growth stimulation.
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The Federal Reserve Bank of San Francisco published research in 2018 that found every recession since 1955 has been preceded by a 2/10 spread reversal that occurred six to 24 months before the recession and gave only one false signal during that time frame.
Anu Gagger, a global investment strategist for the Commonwealth Financial Network, found 28 reversals of the 2/10 spread dating back to 1900, and recessions followed in 22 of those cases. He said in June that the last six recessions started an average of six to 36 months after the curve inverted.
Fox Business’ Megan Henney and Reuters contributed to this report.