The financial world has been abuzz with the recent news: the lengthiest yield curve inversion in U.S. history has finally ended. With the 10-year Treasury yield now around 3.70%, just ahead of the 2-year yield around 3.65%, this slight shift may carry significant implications for the economy. This shift and signs the labor market is cooling could indicate what’s on the horizon.
Why Does the Yield Curve Matter?
In simple terms, the yield curve plots interest rates on Treasury bonds from short-term to long-term. Typically, long-term bonds pay more interest because they require a longer commitment from investors. But when short-term rates exceed long-term ones, it creates an inversion—an unusual situation that often hints at trouble ahead.
Why? Because it shows that investors are betting on slower growth or economic struggles in the future. The reason for this is straightforward: when the bond market believes that economic growth will slow down, long-term yields drop, reflecting pessimism about the future. Short-term rates, on the other hand, are more tied to Federal Reserve policy (which has been raised over the last few years to combat inflation). The curve inverts when investors flock to long-term bonds, fearing an economic slowdown.
Most recently, the inversion of the 10-year and 2-year yields stretched for an unprecedented 783 days, marking the most prolonged period of inversion on record. But now that the curve has returned to a positive slope, many wonder what’s next.
What History Tells Us
History offers some guidance on what could follow. In the past, long-lasting yield curve inversions have often preceded recessions, though the timing and magnitude have varied (this is important). Here are some notable moments:
- March 2007: The yield curve returned to a positive slope, and ten months later, the Great Recession began. The collapse of the housing bubble and subsequent global financial crisis sent shockwaves through markets.
- December 2000: Just four months after the yield curve flipped back, the U.S. economy entered a recession spurred by the bursting of the dot-com bubble. The excesses of tech stock speculation caused widespread market losses.
- June 1989: Thirteen months after the yield curve righted, a recession began, triggered partly by rising oil prices and lingering inflationary pressures.
- October 1981: The U.S. entered a recession two months before the flip in August 1981, as the Federal Reserve fought to bring inflation under control. This resulted in sky-high interest rates that choked off economic growth.
- May 1980: Similarly, the recession that began in February 1980 preceded the yield curve’s normalization by three months. This was another period when inflation-fighting measures led to economic contraction.
The consistent correlation between the yield curve and recessionary periods stands out from these cases. However, it should be clear that some other major catalyst is usually at play.
The Inversion Isn’t Completely Over
The current environment is particularly interesting because while the 10-year and 2-year yields have flipped back, the shortest part of the yield curve remains highly inverted. The 3-month Treasury yield still exceeds the 10-year Treasury yield by more than 1.4%. That part of the curve has been inverted for nearly two years—an extraordinary stretch that speaks to the unusual nature of this economic cycle.
So when will the entire yield curve return to normal? The key here lies with the Federal Reserve.
Rates Will Be Moving Next Week
Currently, analysts have priced in a 100% expectation the Fed will begin cutting interest rates at the upcoming Federal Open Market Committee (FOMC) meeting on September 18. However, the cuts are expected to be modest, with an 87% likelihood of a 25 basis point cut. While this will ease the pressure, it will not be enough to return the entire yield curve to its traditionally upward slope. More aggressive cuts would be needed to fully normalize the curve, which might only happen if the Fed sees more apparent signs of a recession on the horizon.
And if the Fed begins slashing rates in earnest, it could signal that they believe an economic slowdown is not likely but imminent.
Is a Recession Inevitable?
In short, no. Despite the historical precedent, nothing in the world of finance is guaranteed. While yield curve inversions have a solid track record as predictors of recessions, they are not infallible. Remember, we still find ourselves in a unique economic position, brought on by the unprecedented response to COVID-19, which makes the data and historical precedent more unreliable.
The Fed has a tough job to do, no doubt, but they have continued to proclaim their desire for a “soft landing.” Next week will give us our first glimpse of their thinking regarding rate cuts. The magnitude of the cut and the tone of the press conference will go a long way toward setting the stage for how things move from here. I, for one, am excited to see how it goes.
Economy
- It was another volatile week, with inflation news coming in slightly hotter than expected. Nevertheless, the S&P was up 4.0%, the Nasdaq was up 6.0%, and the small-cap Russell 2000 was up 4.4%.
- U.S. Core CPI rose by 0.3% MoM in August, slightly above forecasts of a 0.2% increase and up slightly from the 0.2% increase in July.
- U.S. CPI slowed for a fifth consecutive month to 2.5% in August, the lowest since February 2021, below forecasts of 2.6%.
- Producer prices in the U.S. increased 0.2% MoM in August following a downwardly revised reading in July but above forecasts of 0.1%.
Stocks
- U.S. equities were in positive territory. Technology and Consumer Discretionary were the top performers, while Energy and Financials lagged. Growth stocks led value stocks, and large caps beat small caps.
- International equities closed higher for the week. Emerging markets fared better than developed markets.
Bonds
- The 10-year Treasury bond yield decreased six basis points to 3.65% during the week.
- Global bond markets were in positive territory this week.
- Corporate bonds led for the week, followed by high-yield bonds and government bonds.
