Financial basis

Explanation: several parts of the US yield curve are inverted: what does it tell us?

NEW YORK, Nov 1 (Reuters) – With the market widely expecting the U.S. Federal Reserve to hike interest rates another 75 basis points this week, several parts of the U.S. Treasury yield curve are pointing an upcoming recession.

The US central bank has raised interest rates aggressively this year to fight inflation. Curve inversions essentially reflect traders’ expectations that the Fed will have to cut rates later to help an economy hit by higher borrowing costs. The Fed is expected to raise its target overnight rate on Wednesday to a range of 3.75% to 4.00%.

Yields on two-year Treasury bills have been significantly higher than those on 10-year Treasury bills since early July. Other parts of the curve that the Fed considers more reliable warnings that an economic contraction is expected have also reversed or flattened significantly in recent weeks.

Here’s a quick primer on what a steep, flat, or inverted yield curve means, how it predicted the recession, and what it might signal now.

WHAT SHOULD THE CURVE LOOK LIKE?

The US Treasury funds the federal government’s fiscal obligations by issuing various forms of debt. The $24 trillion Treasury market includes bills that mature between one month and one year, two- to ten-year notes, and 20- and 30-year bonds.

The yield curve, which plots the yield of all Treasury securities, generally slopes upward as the payout increases with 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 that investors are expecting rate hikes in the near term and are pessimistic about future economic growth.

WHAT IS THE CURVE NOW?

Investors view parts of the yield curve as indicators of recession, primarily the spread between three-month Treasury bills and 10-year bonds, and the two- to 10-year (2/10) segment.

Yields on two-year Treasury bills stood at 4.523% on Tuesday while those on 10 years were at 4.035%. This curve has been in deep negative territory for several months now.

The curve plotting the yields of three-month bills against those of 10-year notes, which had already inverted in intraday trading in July, turned negative at the end of last month, closing inverted for the first time since the start of 2020. This negative yield spread stood at -12.1 basis points on Tuesday.

Another part of the curve that Fed Chairman Jerome Powell pointed to as a more reliable harbinger of a recession has flattened significantly, and some analysts have said it could soon reverse. What Fed economists call short-term yield spreads — the differential between the three-month Treasury yield and what the market expects that yield to be 18 months from now — was about 25 basis points. tuesday.

A similar curve, which shows a gap between where money markets expect the three-month fed funds rate to be 18 months from now and the current three-month fed funds rate, reversed briefly. in July and turned negative again at the end of last month. That spread — measured by overnight indexed swap rates (OIS), which reflect traders’ expectations of the federal funds rate — stood at around -16 basis points on Tuesday. read more read more

WHAT DOES AN INVERTED CURVE MEAN?

The inversions suggest that while investors are expecting higher near-term rates, they may be increasingly worried about the Fed’s ability to control inflation without significantly hurting growth. The Fed has already raised rates by 300 basis points this year.

The U.S. curve has reversed before every recession since 1955, followed by a recession in six to 24 months, according to a 2018 report by San Francisco Fed researchers. It only offered a false signal once during this period. This research focused on the part of the curve between 1 and 10 year yields.

Anu Gaggar, global investment strategist for Commonwealth Financial Network, found that the 2/10 spread had reversed 28 times since 1900. In 22 of those cases, a recession followed, she said in June .

For the past six recessions, a recession started an average of six to 36 months after the curve inverted, she said.

Before this year, the last time the 2/10 part of the curve inverted was in 2019. The following year, the United States entered a recession, albeit caused by the pandemic.

WHAT DOES THIS MEAN FOR THE REAL WORLD?

While rate hikes can be a weapon against inflation, they can also slow economic growth by increasing borrowing costs for everything from mortgages to auto loans.

The yield curve also affects consumers and businesses.

When short-term rates rise, U.S. banks raise 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 at lower rates and lend at higher rates. When the curve is flatter, their margins are compressed, which can discourage lending.

Reporting by Davide Barbuscia and David Randall; edited by Megan Davies and Tomasz Janowski

Our standards: The Thomson Reuters Trust Principles.