Has the Fed disabled a recession fire alarm?
Economists and market watchers keep a close eye on the relationship between longterm and shortterm interest rates as a historical indicator of impending recession. In recent days, this signal has been shifting rapidly toward an increased probability of an economic downturn in the months ahead. Yet while that relationship has successfully predicted previous recessions, the immense intervention by the Fed in dealing with the pandemic may have disabled the warning bell. It’s always dangerous to suggest that “this time is different,” but in this case, it could be true.
The relationship between U.S. Treasury bond yields of different maturities is called the term structure or more commonly the “yield curve.” Normally (and intuitively), interest rates on bonds with long maturities are higher than rates for short-term bonds. That typical condition is described by saying the yield curve is upward sloping and can be visualized as a graph depicting higher interest rates as time to maturity increases.
From time to time that normal behavior can be distorted, with shorter rates temporarily rising above longer term rates. That condition in which the slope of the yield curve shifts downward is called an “inversion” and is closely watched. Each of the past eight recessions over the past 70 years was preceded by a yield curve inversion, while there have only been two instances of negative yield curves that did not presage a downturn. So, it is no wonder that so much attention is paid when that powerful indicator flashes yellow.
The buzz intensified this week as one portion of the yield curve did tilt negative with the five-year Treasury yield rising above the 30-year rate. Given the more aggressive actions of the Federal Reserve to tame the current inflationary spike, many observers expect a broader inversion during 2022 and have henceforth raised their odds of a recession for this year or next.
But it is possible the Fed has messed with the yield curve so much the alarm bell is broken.
There are two different metrics commonly used as representative of the term structure. The difference between the 10-year and two-year Treasury bond yields (the 2-10 spread) is most often quoted in the financial press and on Wall Street, has been shrinking steadily over the past year, and may go negative over the next few weeks. A more common metric used by academics is the spread between the 10-year and three-month Treasury yields, which has actually been widening significantly since 2020. Those conflicting signals provide little useful information regarding any pending recession.
It is helpful to understand that the yield curve is a manifestation of investor expectations over differing time horizons. The market rate on the 10-year Treasury incorporates investors’ predictions of future Fed interest rate hikes over that period, but the term of the 3-month T bill is too short to incorporate more than one or two rate increases, holding down the left end of the curve while the 10-year rises. On the other hand, the 2-10 spread reflects the expectation of at least eight or more Fed rate hikes within the horizon of the two-year Treasury, shifting the left end of the curve upward, closing in on an inversion.
And yet, in dealing with the unprecedented economic challenge in 2020, the Federal
Reserve took a page from the financial crisis and soaked it in steroids, purchasing nearly $6 trillion in Treasury bonds and mortgage securities. That massive intervention artificially suppressed the rate on the 10-year maturities by about a full percentage point below where the market would otherwise have priced them. The effect has been to distort the 2-10 curve that would be steeper otherwise. Now that the Fed has ended its purchases, the yield on the 10-year should rise toward fair value, raising the long end of the curve.
Economic growth is clearly slowing in the face of headwinds including energy prices, supply shortages and geopolitical tensions. But a minor inversion in the yield curve in the near term may not necessarily foretell a recession and could be merely an artifact of the colossal rescue operation mounted in response to the pandemic.