Yield curve inversion continues in the often-watched 3-month to 10-year yield spread, which is widely interpreted as a sign of pessimism from fixed income markets. This concern is well founded: Yield curve inversion is statistically one of the strongest predictors that a recession could start in the next one to two years. It takes a brave forecaster to declare that “this time is different,” but there are several reasons why we are not yet sounding alarm bells that a recession is on the horizon for next year.
There are many ways to measure yield curve inversion, and the 3M-10Y spread is certainly closely watched for good reason. However, 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, inversion has not been robust across the yield curve, and the 3M-10Y spread is not as deep as prior episodes preceding a recession.
Since the 3M-10Y yield curve inverted in March, the most pronounced it has been is -25 bps. This falls short of the three prior recessions, when this spread widened more significantly into negative territory, between -35 bps and -95 bps. Still, yield curve inversion has lasted consistently since late May. Many economists who are forecasting a recession in 2020 include yield curve inversion as part of their narrative.
Importantly, other factors are pushing long-term interest rates down, adding to yield curve flattening and inversion. This is contrary to prior episodes where the yield curve inverted when short-term rates were rising as the Fed constrained the economy by raising rates. U.S. long-term rates have plunged 66 bps since the beginning of the year, with more than half of that move coming in mid-May. Trade tensions, a dovish pivot by the ECB and broader global growth concerns have pushed global rates to exceptionally low levels, pulling long-term U.S. rates down with them.
Still, we are watching yield curve inversion very closely. The pessimism of the bond market is casting a shadow over the economic outlook and runs contrary to the optimism seen in the equity markets.
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