December 7, 2018
This past week, one of the telltale signs of a coming recession appeared on investors’ radar. On Monday, the difference between the 10-year Treasury yield, at 2.97%, and the two-year yield, at 2.82%, narrowed by five basis points. It was the most dramatic one-day move since late March.
On Tuesday, the gap narrowed even more to as little as 13 bps as the 10-year hit 2.95%. To bond traders, it was an advance forecast of stormy weather ahead, notwithstanding the ceasefire in the U.S.-China trade war.
The yield curve between longer- and shorter-term bonds has long been a harbinger of economic trouble to come. Here, the 10-year yield has gotten closer and closer to the yield on the two-year. Should the two actually flip, and the two-year yield actually rises above the benchmark 10-year, that inversion would be a signal of a recession, judging by history.
At present, CNBC reported this past week, the two yields are just under 14 bps apart. That’s the narrowest spread since around the time they last inverted in June 2007, when the first signs of what would become the 2008 Great Recession were beginning to appear.
So they’re close, but not yet inverted—does this mean that anxieties about the two yields are premature? Not necessarily. At the same time as the two- and 10-year yields drew closer, the difference between the yields on the three-year and five-year, and those of the two-year and five-year, actually inverted.
“It speaks to the potential for the twos and 10s to invert,” Ian Lyngen, head of U.S. rate strategy at BMO, told CNBC.
The timing could vary, he said, depending on the cycle. However, it’s typically a matter of months, not days or weeks, when such an event could happen.
“That might put 2s and 10s inversion on the table by the end of the year,” Lyngen said. And if it doesn’t happen then, it could occur around the time of the March 2019 meeting of the Federal Open Markets Committee.
Yet, not all analysts see this as a harbinger. For one thing, yield curve inversions have historically been followed by stock market gains.
“Importantly, equities rose 15-16% on average in the 18 months following inversions, with a range of -11% to +30%,” Credit Suisse’s equity strategy team, led by Jonathan Golub, wrote in a note last week.
CNBC points out that the two-year yield is most indicative of Federal Reserve policy. This past week, it maintained roughly the same level as before Fed chairman Jerome Powell said the central bank was close to neutral, implying fewer rate hikes.
At the same time, yield curves might not be the real story. “There’s something going on with worries about growth, notwithstanding [the U.S.-China ] trade deal,” Peter Boockvar, chief investment strategist at Bleakley Advisory Group, told CNBC.
Boockvar said the fact that the agreement to hold off on new tariffs for 90 days while U.S. officials negotiate with their Chinese counterparts had created a 90-day period of uncertainty.
“If I’m a company, I must just hold off until the second quarter to make a decision,” he said. “That could slow growth, just sitting and waiting. Maybe that’s what the bond market is sniffing out.”
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