- The U.S. bond market made headlines today as the spread on 5-year and 2-year Treasury bills inverted for the first time since the Great Recession and risk assets subsequently sold off in force.
- This is important because a yield curve inversion tends to historically lead a turning point in the economy.
- While we believe that the U.S. economy is in the final stages of its expansion, we do not believe that yield curve inversion points to an imminent recession.
The G20-related optimism that had supported markets on Monday gave way to outright pessimism Tuesday as developments in the bond market suggest that the U.S. economy may be headed for a recession. As a result, U.S. stocks ended down over 3% in another volatile day of trading as market participants once again turned their attention to concerns about the U.S. economy. This is because the spread (or difference) between the yield on 5-year and 2-year U.S. Treasury bills turned negative (leading to a yield curve inversion) for the first time since the beginning of the Great Recession.
What the bond market tells us about a recession
Normally, the relationship between shorter duration and longer duration bonds is positive as investors typically seek higher yields for bonds that take longer to mature. Today, the yield on the 2-year Treasury bill was higher than that of the 5-year maturity, signaling an inversion of the typical relationship between these maturities. Economic recessions tend to follow inversions in the yield curve and this is a key reason for today’s risk off market sentiment. Nevertheless, does today’s bond market activity suggest that a U.S. recession is imminent? We believe that this is not necessarily the case.
What should we take away from today’s inversion?
Various studies have been conducted over time trying to identify which treasury spread is the best predictor of a recession. More specifically, which relationship across the yield curve could provide economists with an early warning signal of an impending recession. Examining a wide array of spread measures (summarized in the table below), our work suggests that a yield curve inversion tends to occur 13 months on average before the beginning of a recession (as defined by the National Bureau of Economic Research).
Looking at the various spreads, our work further suggests that while the spread between the 5-2 year yield is important, the difference between the 10-2 year yield holds more weight in terms of consistent timing leading up to a recession.
Referring back to the table above we find that over the past five business cycles an inversion in the 10-2 spread has more or less occurred with a longer lead time than when compared with other common spread measures. This is not to dismiss the point that in 1980 and 2001 an inversion in the spread making headlines today happened much sooner than the 10-2 year spread.
Rather, if we’re looking to history as a guide to what may happen in the future, we would have more confidence in a series of data that has lower variation over time (measured in a lower standard deviation). To this point, the 5-2 year spread making the news has the highest variation in terms of days before a recession among its spread peers, giving it the least predictive consistency from a historical perspective. What we would need to see in order to be convinced that the 5-2 spread is pointing to a recession is not only persistence in this measure, but also confirmation by inversion in other spreads, most notably in the 10-2 year which has among the lowest time variation and longest predictive lead historically.
So what does this mean in terms of a the economy and markets?
We believe that the U.S. economy is in the final stages of its expansion. While we do not believe that we currently are in a recession, today’s yield curve inversion is consistent with our view that a downturn in the economy is likely to begin next year. Indeed, we have written about this point here and here in recent weeks as evidenced in turns in key leading economic indicators.
From a financial markets perspective, we expect that today’s news likely will likely continue to stoke the recession-watch fire for investors. Markets – being the forward discounting mechanisms that they are – likely will begin to price in lower multiples for U.S. and global risk assets as weaker economic releases continue to suggest that the economy is not as healthy as some economists (particularly at the Fed) would suggest. Under these circumstances, today’s yield curve inversion news and subsequent market response is likely just the beginning of more volatility in the coming months.