Historic move in Treasury yields signals high inflation but maybe not a recession anytime soon

Published Wed, Mar 8 20234:37 PM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

The shape of the Treasury yield curve may be flashing the biggest recession warning in nearly 42 years, but some strategists say it may actually be reflecting high inflation, rather than a pending economic downturn. An inverted yield curve is considered a forewarning for recession, and the already-inverted yield curve stretched even wider this week to its most inverted level since 1981. The yield curve becomes inverted when short-duration yields rise above longer duration yields, as in the case of the 2-year Treasury yield and the 10-year yield. At one point on Wednesday, that 2-year to 10-year spread was negative by as much as 111 basis points Wednesday, the widest it has been since September 1981. A basis point equals 0.01 of a percentage point. "Curves like 2s10s in Treasuries crossed the psychological level of -100bps and even though there isn't any economic significance of -99bps vs -100bps, optically it does have more of a 'recession pricing' look to it," wrote Jan Nevruzi of NatWest Markets. 10Y2YS 1Y line inversion Recession or a sign of inflation? Wall Street's strategists and economists have disagreed about whether the curve inversion has been actually foretelling an economic contraction and if so, when that recession might begin. "The [inversion] means we're facing much higher inflation than expected, and the fact the Fed has to go to a much higher terminal rate than was previously hoped for," said Andrzej Skiba, head of U.S. fixed income at RBC Global Asset Management. "At the same time, the U.S. economy is doing fine. The current shape of the yield curve tells you more about sticky inflation." Comments from Federal Reserve Chairman Jerome Powell this week sparked the move wider in the spread. He told Congress that the Fed may have to drive interest rates to higher-than-anticipated levels because of inflation. The short-end of the curve, or 2-year yield was at 5.06% Wednesday afternoon, while the 10-year was yielding just under 4%, at 3.98%, The 2-year most reflects Fed policy. The 10-year yield more reflects the outlook for economic growth. "[The inverted curve] historically was a harbinger of recession coming further down the line, but in our opinion, it doesn't mean automatically that any hope of a soft landing scenario is gone," said Skiba. He said his forecast does include recession, but there's been an increasing chance the U.S. could dodge a period of negative growth because of the strength of the economic data, he said. Skiba also said the higher interest rates have not had as much impact on the consumer as they might have because of both the strength of the labor market and the fact that many homeowners locked in low rate mortgages before interest rates began to rise. "Yes by historical standards with this kind of inversion, it is fair to expect recession further down the line, but we're not saying it's a given that this curve means a recession is coming over quarters to come because both the U.S. economy and the consumer are in much better shape coming into a potential slowdown than was anticipated," Skiba said. That makes all of the incoming economic data more important, including Friday's February employment report and the consumer price index on March 14, he added. Watching for a reversal of the inversion Jonathan Golub, chief U.S. equity strategist at Credit Suisse, said the curve could be warning of a recession, but the futures market indicates it may not be until January 2026, when futures show the curve coming out of its inverted state. Golub said the outcome of the inverted curve's recession warning has been different in periods of high inflation versus low inflation. The inflationary years in the 1970s and 1980s were different than the 1990s and later. For instance, he said when inflation was high, recessions began an average of five months before the curve inversion ended, while recessions come more quickly when inflation is low. During low inflation periods, recessions arrived an average five months before the inversions ended. "Over the past 50 years (excluding the pandemic period), the curve has inverted 6 times, with recessions following by 11 months on average, with no false positive or negative indications. With the yield curve inverted since last October, it is no surprise that bearish pundits are predicting an economic downturn," Golub said in a note. "Using the high inflation period as a guide, futures point to an August 2025 recession onset, roughly 2½ years from today." Golub said in a phone interview that the arrival of a recession is the logical outcome. "It's not the curve inverting that is the issue. It's the reversal of it," he said. "What happens here is you have inflation and the Fed tightens rates. They start to raise rates. The market starts to anticipate a recession, so the 10-year bond yield is lower, and the 2-year is higher because it's fighting inflation. The long rates and short rates are tied to different signals." When the economy begins to weaken, the Fed removes some of its tightening, and short-term rates begin to fall. "The curve uninverts because the Fed sees a recession, and they respond to it," said Golub. "You could also argue that [the reason] it takes longer for the curve to uninvert in a high inflation environment is because the Fed is forced to become more draconian in their actions when inflation is high." It's not surprising that some on Wall Street sees a recession coming sooner. "Why is it people are predicting recession sooner, rather than later? The No. 1 recession indicator is the steepness of the yield curve. They're using an old playbook, after the last three recessions and how long after the Fed's pause," he said. "If you look at the last three recessions, we should be moving into this recession soon."