These aren’t the recession signals you’re looking for


Over the past 40 years, the US economy has gone into recession 6 times. Over those 40 years, the difference between 10-year yields and 2-year yields (2s10s curve) reliably dipped into negative territory on average about 18 months before GDP turned negative (Chart 1). Today, the 2s10 curve hits again on the verge of reversing (while some curves like the 3s10 and 5s10 are already reversing), causing quite a stir among market watchers that a recession is imminent. While growth may certainly slow as the Fed attempts to rein in inflation, our work suggests investors will be better served by looking elsewhere for signals of recession. In fact, our models show that the flattening of the curve could be more of a consequence of the Fed’s relentless bond buying and consequent growth of its balance sheet, rather than an impending growth shock. As such, the true fair value of the 2s10 gap could be in the 150bp to 200bp range had the Fed never engaged in its multiple rounds of quantitative easing.

Up, down, all around…

The trick with looking at yield curves is that investors need to consider two variables: the short end of the curve (the 2-year rating) and the long end of the curve (the 2-year rating). in 10 years). While this may be obvious, it is important to point out that curve flattening can be a function of any combination of directional movements in yield as long as the 2yr rises more (falls less) than the 10yr. .

Depending on how the curve flattens, and why, it could make a difference in determining whether the signal it sends today is the canary in the coal mine, or conversely, just noise.

To determine what is the case today, we must ask ourselves why the 2s10 curve tends to be a reliable signal of recession? Historically, this is because when the two measures intersect, it indicates that the market expects policy (which is driving the 2-year rating) to become too restrictive, cutting bank lending and sending the economy into recession (the 10-year note indicates long-term growth) . So, looking back over the last 4 recessions and the curve inversions that occurred before each one, we find that 75% of the time the 10-year yield fell while the 2-year yield rose. And in 2 of the 3 cases, most of the flattening was due to falling 10-year yields. In other words, at such times, the restrictive market price policy (which translates into rising 2-year yields) would hamper long-term nominal growth (10-year yields falling).

Table 1

Today, we are witnessing a very different dynamic.

  1. The 10-year yield has risen 65 basis points since curve flattening began nearly a year ago. A rise in the 10-year does not suggest fears of slowing growth, whatever the 2-year note does.
  2. The 10-year yield, as we’ve mentioned several times, has been anchored by the Fed’s expansion of its balance sheet and ownership of the long end of the curve.

The second point above cannot be overstated. As we have discussed in previous reports, since the Global Financial Crisis (GFC), there have been four main drivers of Treasury yields: inflation, leading economic indicators (LEI), fund rate feds and the size of the Fed’s balance sheet relative to GDP. These four indicators suggest that rates should now be closer to 3%. We think the market is finally waking up to this reality.

Additionally, our work suggests that if the Fed had never engaged in quantitative easing, the 10-year would likely be closer to 3.7%. rather than the current 23 basis points. While the Fed is likely to maintain a sizeable balance sheet, thereby keeping yields relatively anchored compared to what would have been expected if it had never bought bonds, there is a clear potential for yields to rise over the long term over the next few months. quarters. Whether or not that happens with ever-higher 2-year yields, time will tell, but for now, we would be looking for other indicators of recession.

Michael Contopoulos

Director of Fixed Income

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