NEW YORK, March 29 (Reuters) – The U.S. Treasury yield curve inverted on Tuesday for the first time since 2019 as investors priced in an aggressive rate hike plan from the Federal Reserve as it attempts to lower inflation from 40-year highs. .
Here’s a quick primer explaining what a steep, flat, or inverted yield curve means and how it predicted a recession in the past, and what it might signal now.
WHAT SHOULD THE CURVE LOOK LIKE?
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The US Treasury funds the federal government’s fiscal obligations by issuing various forms of debt. the $23 trillion The Treasury market includes Treasury bills with maturities of one month to one year, two-year to 10-year notes, as well as 20- and 30-year bonds.
The yield curve represents the yield of all Treasury securities.
Typically, the curve slopes upward because investors expect greater reward for taking the risk that rising inflation will reduce the expected return from holding longer-dated bonds. This means that a 10-year note generally pays more than a two-year note because it has a longer duration. Yields move inversely to prices.
A steepening curve generally signals expectations of stronger economic activity, higher inflation and higher interest rates. A flattening curve may mean the opposite: investors are expecting short-term rate hikes and have lost confidence in the economy’s growth prospects.
WHAT DOES AN INVERTED CURVE MEAN?
Investors see parts of the yield curve as indicators of recession, primarily the spread between the yield of three-month Treasury bills and 10-year bonds and the US two-year to 10-year curve (2/10 ) .
On Tuesday, the 2/10 part of the curve inverted, meaning 2-year Treasury yields were actually higher than 10-year Treasury yields. This is a wake-up call for investors that a recession could follow.
The U.S. curve has inverted before every recession since 1955, with one recession following between six and 24 months, a 2018 study found. report by researchers at the Federal Reserve Bank of San Francisco. It only offered a false signal once during this period.
According to Anu Gaggar, Global Investment Strategist for Commonwealth Financial Network, who looked at the 2/10 part of the curve, there have been 28 instances since 1900 where the yield curve has inverted; in 22 of those episodes, a recession followed. The lag between curve inversion and the onset of a recession has averaged about 22 months, but has ranged from 6 to 36 months for the past six recessions, she wrote.
The last time the 2/10 part of the yield curve inverted was in 2019. The following year, the US entered a recession – albeit caused by the global pandemic.
WHY IS THE YIELD CURVE INVERTING NOW?
Yields on short-term US government debt have risen rapidly this year, reflecting expectations of a series of rate hikes by the US Federal Reserve, while yields on longer-term government bonds have moved at a slower pace amid concerns that policy tightening could hurt the economy .
As a result, the shape of the Treasury yield curve has generally flattened and, in some cases, inverted.
Other parts of the yield curve have also inverted, including the spread between five-year and 30-year U.S. Treasury yields, which fell below zero this week for the first time since February 2006, according to data from Refinitiv.
ARE WE GETTING MIXED SIGNALS?
Yet another closely watched part of the curve sent a different signal: the spread between the yield on three-month Treasuries and 10-year Treasuries this month widened, raising doubts that a recession is imminent.
Meanwhile, the two-year/10-year yield curve has technical issues, and not everyone is convinced that the flattening of the curve is telling the truth. They say the Fed’s bond-buying program of the past two years has led to an undervaluation of the US 10-year yield that will rise when the central bank begins to shrink its balance sheet, steepening the curve. Read more
Fed researchers, meanwhile, published a document March 25 which suggested that the predictive power of spreads between 2- and 10-year Treasuries to signal a coming recession is “probably wrong”, and suggested that a better herald of a coming economic downturn is the spread of Treasury bills with maturities of less than 2 years.
WHAT DOES THIS MEAN FOR THE REAL WORLD?
While rate increases can be a weapon against inflation, they can also slow economic growth by increasing the cost of borrowing for everything from mortgages to auto loans.
In addition to the signals it can send about the economy, the shape of the yield curve has ramifications for consumers and businesses.
When short-term rates rise, U.S. banks tend to raise their benchmark rates for a wide range of consumer and commercial loans, including small business loans and credit cards, making borrowing more expensive for consumers. Mortgage rates are also rising.
When the yield curve steepens, banks can borrow money at lower interest rates and lend at higher interest rates. Conversely, when the curve is flatter, their margins tighten, which may deter them from lending.
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Additional reporting by Daniel Burns; Editing by Megan Davies, Nick Zieminski and Andrea Ricci
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