Source: Macrobond. Shaded areas represent NBER-dated recessions.
Q1 wound down with a sizable drop in long-term yields that pushed the 10-year U.S. Treasury yield below the 3-month Treasury bill interest rate for the first time since 2007, also known as yield curve inversion. Alarm bells went off in financial markets because yield curve inversion is statistically one of the strongest predictors that a recession could start in the next one to two years. With the U.S. economy expected to slow and global growth concerns top of mind, “recession watch” seems to have begun.
There are many ways to measure yield curve inversion, and one of the most widely watched pairings is the 3-month and 10-year yield spread (3M-10Y), which briefly moved into negative territory at the end of March. Even temporary yield curve inversion should not be ignored, and many economists who are forecasting a recession in 2020 include yield curve inversion as part of their narrative.
However, March’s yield curve inversion falls short of market conditions that have typically preceded past recessions. Looking at the three prior recessions, the 3M-10Y yield curve inversion lasted for several months, and the spread dipped into negative territory more significantly, between -35 bps and -95 bps. The 2Y-10Y curve is also an important leading indicator of recession, and though it remains relatively flat, it has not inverted. In other words, yield curve inversion has technically happened, but not robustly.
Critically, other factors are pushing long-term interest rates down, adding to yield curve flattening and inversion. This is contrary to prior episodes when the yield curve inverted because short-term rates were rising as the Fed constrained the economy by raising rates. Uncertainty surrounding Brexit and other central banks’ continued bond-buying programs has pushed global rates to exceptionally low levels, pulling long-term U.S. rates down with them.
Still, it takes a brave forecaster to declare that “this time is different.” We are watching yield curve inversion very closely, and the flat yield curve is a sign of broader uncertainty about long-term growth prospects. We do not forecast a recession, but yield curve inversion casts a shadow over the economic outlook.
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