Explainer – Several parts of the US yield curve are inverted: what does that tell us? – US News & World Report Money | CarTailz

By Davide Barbuscia and David Randall

NEW YORK (Reuters) – With the market broadly expecting the Federal Reserve to hike rates by another 75 basis points this week, several parts of the US Treasury yield curve are pointing to an impending recession.

The US Federal Reserve has raised interest rates aggressively this year to fight inflation. Curve reversals essentially reflect traders’ expectations that the Fed will later have to cut rates to help an economy hurt by higher borrowing costs. The Fed is expected to raise its overnight lending rate target to a range of 3.75% to 4.00% on Wednesday.

Since the beginning of July, the yields on two-year Treasuries have been well above those on ten-year Treasuries. Other parts of the curve that the Fed sees as more reliable warnings of an expected economic slowdown have also reversed or flattened significantly in recent weeks.

Here’s a quick primer on what a steep, flat, or inverted yield curve means, how it predicted a recession, and what it might be signaling now. WHAT SHOULD THE CURVE LOOK LIKE? The US Treasury Department funds the federal government’s budgetary obligations through the issuance of various forms of debt instruments. The $24 trillion government bond market includes bills maturing in one month to one year, two to ten year notes, and 20 and 30 year bonds. The yield curve, which represents the yield on all government bonds, typically slopes up as the payout increases with duration. Yields move inversely with prices. A steeper curve typically signals expectations for stronger economic activity, higher inflation and higher interest rates. A flattening curve may mean that investors are anticipating short-term interest rate hikes and are pessimistic about future economic growth.

WHAT DOES THE CURVE LOOK LIKE NOW?

Investors are watching parts of the yield curve as recession indicators, most notably the spread between 3-month Treasury bills and 10-year debt and the 2-10 year (2/10) segment.

Two-year government bond yields came in at 4.523% on Tuesday, while the 10-year was at 4.035%. This curve has been in deep negative territory for several months.

The curve plotting yields on three-month bills versus 10-year notes, which had already reversed in intraday trading in July, turned negative late last month, closing inverted for the first time since early 2020. That negative yield spread was -12.1 basis points on Tuesday.

Another part of the curve that Fed Chair Jerome Powell has called a more reliable predictor of a recession has flattened significantly, and some analysts said it could soon reverse. What Fed economists call short-term forward yield spreads — the difference between the three-month Treasury yield and the market’s 18-month expected yield — stood at about 25 basis points on Tuesday.

A similar curve, showing a range between the three-month federal funds rate that money markets are expecting 18 months from now and the current three-month federal funds rate, reversed briefly in July and turned negative again late last month. That spread — as measured by overnight indexed swap (OIS) rates, which reflect traders’ expectations for the federal funds rate — was around -16 basis points on Tuesday. WHAT DOES AN INVERTE CURVE MEAN?

The inversions suggest that while investors expect higher near-term interest rates, they may become nervous about the Fed’s ability to control inflation without significantly hampering growth. The Fed has already hiked rates by 300 basis points this year.

According to a 2018 report by San Francisco Fed researchers, the US curve has inverted before every recession since 1955, with a recession following in six to 24 months. It only gave the wrong signal once during that time. This research focused on the portion of the curve between one- and ten-year returns.

Anu Gaggar, Global Investment Strategist for the Commonwealth Financial Network, noted that the 2/10 spread has reversed 28 times since 1900. A recession followed in 22 of those cases, she said in June.

In the last six recessions, on average, a recession started six to 36 months after the curve inverted, she said.

Prior to this year, the 2/10 part of the curve inverted for the last time in 2019. The following year, the United States entered a recession, albeit one caused by the pandemic. WHAT DOES THIS MEAN FOR THE REAL WORLD? While interest rate hikes can be a weapon against inflation, they can also slow economic growth by raising the cost of borrowing on everything from mortgages to car loans. The yield curve also affects consumers and businesses. When short-term interest rates rise, US banks raise benchmark interest rates on a wide range of consumer and business loans, including small business loans and credit cards, making it more expensive for consumers to borrow. Mortgage rates are also rising. As the yield curve steepens, banks can borrow at lower rates and lend at higher rates. When the curve is flatter, their margins are squeezed, which can discourage lending.

(Reporting by Davide Barbuscia and David Randall; Editing by Megan Davies and Tomasz Janowski)

Copyright 2022 Thomson Reuters.

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