Fears of an imminent recession are somewhat overblown. These fears are showing up in fixed-income markets, where investors are betting that the risk of a recession is rising as the economy absorbs a supply shock in the commodity and energy markets and as central banks increase interest rates.
But economic fundamentals show that the probability of a recession over the next 12 months is roughly 20%, which is up modestly compared to before Russia’s invasion of Ukraine.
Economic fundamentals show that the probability of a recession over the next 12 months is roughly 20%.
Once one accounts for the sharp moves in yields and the shape of the term spectrum, that probability jumps close to 35%, which denotes some risk but does not imply a sustained downturn consistent with what defines a recession.
Beyond these probabilities, a closer look at the different components of the yield curve reveals a more nuanced picture. The near-term forward spreads, or the three-month/18-month spread as well as the 10-year/three-month spread, both imply sustained growth compared to the inversion of the 10-year/two-year spread.
That is consistent with the strong labor market, solid consumer spending and businesses’ increase in productivity-enhancing investments despite rising inflation.
When using the shape of the yield curve as a method of forecasting, we note that the 10-year/two-year spread cannot be relied on to predict an immediate recession.
One reason is that the structure of the economy has changed significantly over the past decade, so many of the old rules of thumb around identifying potential pivot points in the economy have changed as well.
It’s important for investors and managers to consider a range of alternative indicators when making decisions for investments and hiring.
Right now, those indicators are in flux and are implying different directions of growth in the American economy.
Current state of play
Everything about the end of the last business cycle and recovery has occurred in double time.
Alternative economic indicators are in flux and are implying different directions of growth in the American economy.
This includes the 2018 trade war and the subsequent global manufacturing recession, the economic shutdown of the pandemic, the economic reopening and the spread of the subsequent variants, the rise in workers leaving the labor force, the rapid discovery of vaccines, the breakdown of the supply chain, and, now, geopolitical conflict.
After the pandemic broke out, monetary authorities acted swiftly and avoided a worldwide economic collapse. And in its aftermath, they applied the appropriate caution for fear of damaging the sustainability of the recovery.
But only two years after the initial economic downturn, central banks find themselves fighting inflation while a war in Ukraine rages.
Already, financial market observers are worried that tighter monetary policy and the geopolitical risk premium have thrown a monkey wrench into the recovery and could send the economy into recession.
There is certainly a basis for those concerns, particularly given the geopolitical upheaval and the direct and indirect costs of Russia’s attack on Ukraine. The volatility in commodity and financial prices have become a major disruption in the investment decision process and in the profitability of business.
Financial market analysts—looking for clues to the direction of the economy—are warning of the reaction of the bond market to the events of the first three months of this year.
Is the bond market yield curve pricing in a recession? It all depends on which section of the yield curve you’re looking at.
The interest rate differential between 10-year Treasury yields and the three-month Treasury bill rate is increasing, a sign of a recovery in the making. But at the same time, the spread between 10-year and two-year bond yields looks to be heading in the wrong direction—toward a yield curve inversion in which short-term interest rates are higher than long-term interest rates, the anomaly that typically precedes a recession.
We estimate that there will indeed be an economic slowdown, a result of product shortages and further disruptions in the global supply chain caused by the war in Ukraine. But there are many factors mostly out of our control, and we still pay attention to what the bond market is telling us.
In the discussion that follows, we’ll look at the roles of money market rates and two-year and 10-year bonds in this shortened recovery period, and then the role of the forward market in the formulation of monetary policy.
An abbreviated business cycle?
Under normal circumstances, this month’s increase in the federal funds rate would be a welcome indication of the sustainability of a business cycle uptrend after an economic downturn.
Under normal circumstances, this month’s increase in the federal funds rate would be a welcome indication of the sustainability of a business cycle uptrend.
But these are anything but normal times. Instead, we are in a post-pandemic era of lingering shortages, production shutdowns, rising inflation and surging demand, all capped by a threat to world order.
Clearly, short-term interest rates have been too low for too long and are once more limiting the range of monetary policy responses if another economic or financial crisis were to occur.
Consider that it was only a matter of months after the U.S. trade war derailed the Federal Reserve’s 2015-18 program of interest rate normalization that the pandemic forced the Fed’s hand and sent its overnight policy rate back to the zero bound.
But thanks to the vaccines and a remarkable economic recovery, in less than two years the Fed was signaling its intent to move toward a normal interest rate policy.
We would also note that low-for-long interest rates have the propensity to create asset bubbles—as we’ve seen in the housing market and the stock market. For that reason, an adequate return on long-term investment is crucial for the stability and growth of investment.
The Fed’s intent to raise its overnight policy rate did not go unnoticed before the war in Ukraine. Because interest rates are determined by the expected path of short-term rates for the duration of the security, plus the risk premium for holding longer-term securities, interest rates along the yield curve have been rising for the past six months.
In fact, this month’s 25 basis-point rate hike in the federal funds rate has already been met with a 200 basis-point increase in the yield of two-year Treasury bonds since September 2021, a 160 basis-point increase in five-year yields, a nearly 100 basis point rise in the 10-year and a 55 basis-point increase in the yield of a 30-year bond. This did not happen overnight.
The bond market and the business cycle
Wall Street and the economic community have long considered the yield curve as the arbiter of the health of the business cycle.
An upward sloping yield curve—in which yields increase along with the maturity of a bond—is considered normal within a healthy and growing economy.
Think of it as businesses borrowing at lower money-market rates available at the short end of the curve in order to invest in the higher returns available for longer-term investments at the long end of the curve.
In contrast, a downward sloping yield curve—in which short-term securities have higher yields than long-term securities, referred to as an inverted yield curve—indicates potential distress within the economy and is a bearish signal for Wall Street.
Higher short-term rates are typically a result of an aggressive monetary policy, with a series of Fed rate hikes cooling both an overheating economy and above-normal rates of inflation.
And because monetary policy and external shocks are transmitted to the economy through financial conditions, the diminished willingness to borrow or to lend at the end of a business cycle becomes a self-fulfilling drag on economic activity.
According to a 2018 analysis by the Federal Reserve Bank of St. Louis looking at the yield spread between 10-year Treasury bonds and three-month T-bills, “yield curve inversions have regularly occurred prior to periods of economic recessions since the 1960s” and are as reliable a predictor of business contractions as increases in unemployment.
In the current episode, yields of 10-year bonds have moved higher as confidence in the economic recovery took hold at the same time that the Fed has held short-term rates at the zero bound. The result is an increasing spread between 10-year bond yields and three-month rates, which hardly seems a cause for alarm.
Two-year Treasury yields
Because of the proximity of two-year Treasury yields to the Fed’s overnight rate, the current two-year yield of 2.3% is considered to be a proxy for the federal funds rate in two years’ time.
As our analysis shows, Fed rate-hike regimes tend to be preceded by increases in the yield on two-year bonds. Similarly, rate-cut regimes tend to be preceded by decreasing trends in two-year yields.
Ten-year Treasury yields
Further out the yield curve, the yield on 10-year bonds becomes less sensitive to the level of overnight rates and more sensitive to the risk of holding the bond for a much longer period of time.
For that reason, the current 2.45% yield on a 10-year bond is more indicative of perceptions of economic growth and inflation, with a growing economy implying higher rates of return on investment and inflation.
Put simply, while the secular decline in 10-year yields since the 1980s results from the squeezing of inflation out of a slower-growing economy, the more volatile course of two-year yields is in reaction to the ups and downs of monetary policy.
Ten-year and two-year T-bills
Market observers are looking to the interest-rate differential between 10-year and two-year Treasury bonds yields as an indication of an impending recession.
Two-year yields are spiking higher relative to the overnight funds rate, while changes in the three-month rates have remained subdued.
We note that yield curve slopes measured by the 10-year less three-month rates and the 10-year less the two-year yield are telling distinctly different stories. We attribute that to the different roles of the three-month rate and the two-year rate.
The three-month rate is held hostage to the Fed’s overnight policy rate and the Fed’s efforts to maintain liquidity in the commercial markets for short-term funding.
The two-year bond yield is determined by expectations for the federal funds rate in two years’ time. As such, two-year yields are spiking higher relative to the overnight funds rate, while changes in the three-month rates have remained subdued.
As in other rate-hike episodes that typically occur at the end of business cycles, the spread between the 10-year and two-year becomes negative before a recession.
In the last three business cycles, these yield curve inversions occurred roughly 14 months before the 2001 dot.com recession in 2001, 25 months before the Great Recession in 2007-08, and only seven months before the pandemic recession in 2020, noting that the 2019 inversion was very brief.
So how can we explain these inversions? At the end of a business cycle, you would expect the increases in 10-year bonds to moderate, considering the deceleration of expectations for growth.
And because of higher inflation at the end of a business cycle—stemming from rising demand from consumers with income to spend—you would expect a response from the Fed in the form of rate hikes.
In this current episode, expectations for the Fed’s response to the post-pandemic recovery and rising inflation have been gaining momentum, and two-year yields have responded accordingly.
At the same time, the market for 10-year Treasury bonds has been buffeted by safe-haven demand for U.S. securities, concerns of lower growth because of tighter monetary policy pressuring yields lower, and the threat of unconstrained inflation pressuring yields higher.
Perhaps the best thing to say is that while the U.S. looks to be able to withstand the withdrawal of Russian oil from the market, there is an extraordinary amount of uncertainty to be priced in regarding prices for food and energy and the health of the global economy in the coming months.
If we were to expect the Fed to continue hiking its policy rate to constrain inflation expectations—and to give it some latitude should the crisis worsen—we would expect a 10-year/two-year yield curve inversion at some point.
Gleaning the Fed’s moves
We can look to the money market to give us an idea of near-term expectations for Fed policy. Three-month money market rates are closely attached to the overnight federal funds rate. So the 18-month forward rate for a three-month security should be a proxy for expectations of where Federal Reserve policy and the federal funds rate are heading.
As our analysis shows, the forward rate tends to lead the direction of the three-month cash rate, moving higher during periods of economic recovery and dropping below the three-month rate in anticipation of policy stalling and eventual rate cuts.
In this current episode, the spread between the forward rate and the cash rate has surged to more than two percentage points, implying that money markets are anticipating eight 25 basis-point rate hikes over the next 18 months.
Our assumption is that the Fed is a close observer of the 18-month forward spread, using it to see if the market is keeping up with or moving ahead of Fed policy.
Yield curve inversions, which result from aggressive tightening of monetary policy, have preceded each of the recessions since the 1960s. The spread between 10-year Treasury yields and three-month T-bill rates is far from calling for a recession.
The forward market is nevertheless anticipating the Federal Reserve to continue tightening monetary policy, with multiple rate hikes over the next 18 months.
Because two-year bond yields are a proxy for expectations for the federal funds rate in two years’ time, the spread between 10-year and two-year bonds yields is shrinking. If that were to continue, the subsequent yield curve inversion would signal a slowing economy or the eventual end of an abbreviated business cycle.
While we expect a slowdown of what appears to be a healthy economy, geopolitical upheaval makes it impossible to forecast growth without a solid dose of caveats and conflicting developments. Consider these:
- Rising prices: Inflation expectations remain subdued—a testament to the Fed’s ability to control inflation and which might avoid the overly aggressive monetary tightening that has brought down the economy in previous episodes.
- Russian energy: For now, the withdrawal of Russia energy from the world market is limited by Europe’s continued reliance on the Russian supply. The effect of increased energy and food prices will vary according to income levels.
- Commodities: Commodity trading and bond market trading have become highly volatile. The start-up Chicago Fed commodity trading facility should have an impact on the financialization of the commodity markets in the same vein as the New York Fed’s intervention in the money markets.
- Looking to next winter: The European Union is already taking steps to prevent energy shortages next winter and is researching price controls. Next winter, though, is a long way off.