Economists want signs of a slowdown in the yield curve

Economists—such as ancient forecasters of the future—track how interest rates of different maturities differ for signals about the outlook for growth.

When short-term interest rates are higher than long-term interest rates, Wall Street’s phenomenon called an inverted yield curve is sometimes a sign of recession.

The astrologers were worried about this.

The closely watched gap between yields on two-year and 10-year Treasury notes turned upside down this week. On Friday, the yield on two-year Treasury notes lagged at 2.44% and on 10-year notes at 2.38%.

Steve Englander, an investment strategist at Standard Chartered Bank, observed similar signals emerging from the Eurodollar futures markets, where traders bet on future rates. They found that the expected short-term rates at three years and four years were lower than the rates expected at two years.

“It’s generally a sign that bad times are ahead, with a recession or at least a downturn expected,” he said. “The market is convinced it’s going to end in tears.”

In normal times, the longer it takes to repay the loan, the higher the interest rate you have to pay. Lending money over a longer period carries more risk and thus demands higher returns.

The interest rate for a three-month loan, in other words, should be lower than the interest rate for a two-year loan, which should be less than a 10-year loan. When these relationships reverse, it is a sign of turbulence on the horizon that often involves the Federal Reserve.

In the early and late 1980s, before the recession, the yield curve was inverted. This happened again in the early 2000s and before the recession in the mid-2000s.

The logic is as follows: Investors expect the Fed to raise interest rates so much in the short term to fight inflation that it ends up squeezing credit, causing a recession and reversing those rates further down the road.

Higher short-term interest rates are driven by expectations of a Fed interest rate hike and longer-term rates are driven by expectations of a recession, a subsequent fall in inflation and subsequent Fed rate cuts.

Beyond these indications, the inverted yield curve can cause practical problems. Banks usually borrow money in the short term and lend in the long term. When short-term rates are higher than long-term rates, banks face profit pressure and incentives to lend, which also reduces economic activity.

This week Wall Street’s inbox was filled with notes like Mr Englander’s, titled “Reversing rates as a glowing yellow for the Fed.”

Sometimes a yield-curve reversal and recession is the necessary price to bring down high inflation, as was the case in the early 1980s when then-Fed Chairman Paul Volcker introduced higher interest rates to reduce double-digit inflation. was used.

Other times, the Fed probably goes too far. In 2006, the central bank pushed its benchmark short-term rate above 5%, while long-term interest rates remained below that level. A lower long-term rate may be an indication that the market expected inflation to moderate, and did not require a rate increase. A financial crisis and recession followed in 2007 and 2008.

Because of this history, Fed officials care deeply about the signals the yield curve sends.

In some cases the Fed has reversed course and averted recessions during cycles of interest rate hikes, as it did in 1998. It reversed course in 2019 as well, and the recession could have been avoided had the Covid-19 pandemic not happened.

Right now, Fed officials say they have time before such concerns become relevant.

Yield curves can be measured using interest rates across a wide spectrum of maturities from overnight to 30 years, and some inverses matter more than others. Although investors often see the difference between yields on two-year and 10-year Treasury notes, Fed researchers Eric Engstrom and Steven Sharp concluded that it was not the rates that really mattered.

They found that the correlation of rates over shorter time horizons of less than two years was a more accurate measure of recession risk. They compare current three-month Treasury-bill rates with market expectations for future three-month rates. Using that approach, bearish alarms are not sounding. Short-term rates are much lower than expected rates 18 months from now.

“There is no need to fear the 2-10 spread,” Messrs. Angstrom and Sharp argued in a recent paper.

Fed Chairman Jerome Powell seemed to support the idea in remarks to the National Association for Business Economics in March. Like Mr. Angstrom and Mr. Sharp, he said, “I look at the smaller part of the yield curve.”

What is an investor to make of this predictor?

Taken all together, the yield-curve signals seem to suggest that the Fed has room and time to raise short-term interest rates from their rock-bottom levels in the coming months.

The central bank expects inflation to ease as supply constraints ease in the economy. If inflation doesn’t ease as expected and the central bank goes ahead with rate hikes in 2023 or beyond, a recession could become more of a threat than it is now.