Given the risk inherent in holding fixed income securities, investors expect to be compensated for locking in their money for longer periods of time, rather than simply rolling over shorter maturities. This incremental compensation is known as the term bonus. Long-term returns are equal to long-term nominal growth expectations plus a term premium.
Yield curve inversions occur when securities with shorter maturities offer higher yields than securities with longer maturities. At first glance, this would seem absurd as there is no obvious reward for tying up capital for a longer period. But reversals occur periodically, when the Federal Reserve’s monetary policy tends toward restraint and demand for longer-dated securities increases to such a degree that investors are forced to accept a lower yield as a result. In most cases, these reversals are temporary aberrations and generate little excitement.
But not always. The financial media’s fixation on the shape of the Treasury curve intensified in early April, when the yield on the 2-year note exceeded the yield on the 10-year note. The difference was not large – less than 10 basis points separated the yields offered – but the “reversal” was enough to trigger a scramble among market watchers who wondered if the event did not herald a recession. economic. A 2s/10s reversal has often been cited – and was again last week – as a reliable indicator of recession, even though it is not a direct cause. This is true up to a point, but the lag between the indicator and the actual event can be long.
Recessions are almost always preceded by a flat or inverted yield curve. There have been many 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 widely held belief that the Fed will be wrong by tightening monetary policy too abruptly. Investors may believe that it is safer to put money in longer-term bonds than to commit capital elsewhere in the face of a tighter monetary regime. To the extent that the Fed tightens too quickly, the cost of capital becomes higher than the return on capital, which constrains lending and limits economic activity.
We believe 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 that the spread between the 2-year and 10-year yield is less useful as a forward-looking indicator of economic recession than the spread between the 3-month note and the 10-year note. Shorter maturities, such as 3-month bills, are more directly influenced by Fed-controlled overnight rates. The 2-year/10-year spread is often the spread highlighted in the popular press, but it is the 3-month/10-year spread that best reflects banks’ net interest margins. And the proposed three-month yield is still well below the 10-year yield. 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.
Additionally, in today’s unique environment, inflation is expected to be significantly higher in the coming quarters due to supply chain bottlenecks and pandemic-related shutdowns in Asia. The longer-term inflation outlook beyond 12 months is more subdued. Real yields are significantly more negative in the short term than in the long term, so investors should not ignore the upward slope of the real yield curve when assessing near-term growth prospects.
Investors should not ignore trends in the shape of the yield curve. But they shouldn’t panic over the recent media attention either. The yield curve has been a useful forward indicator for predicting future recessions, but the 3-month/10-year spread is the best marker. The unique influences in today’s market are accelerating a reversal in the shape of the 2-year/10-year yield curve more than fundamental indicators suggest. We cannot rule out a deeper and more widespread inversion of the yield curve in the future if the Fed tightens significantly above the neutral rate, but an imminent near-term recession seems unlikely to us.
The 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 Changing Shape of the Yield Curve, April 14, 2022.