Explanation: the US yield curve is inverted again: what does it tell us?


The US dollar banknote in front of the stock chart is seen in this illustration taken June 12, 2022. REUTERS/Dado Ruvic/Illustration

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NEW YORK, July 5 (Reuters) – A closely watched part of the U.S. Treasury yield curve inverted again on Tuesday as investors continue to price in the possibility that the Federal Reserve’s aggressive move to cut the inflation plunges the economy into recession.

Yields on two-year Treasuries briefly topped those on 10-year Treasuries for the third time this year, a phenomenon known as yield curve inversion that has preceded U.S. recessions in the past. .

It comes amid a chorus of growth warnings on Wall Street, as a Fed bent on bringing inflation down for more than 40 years sets the course for an aggressive tightening of monetary policy that, according to the investors, will also hurt US growth.

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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 $23 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 economic growth.

WHAT DOES AN INVERTED CURVE MEAN?

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.

On Tuesday, yields on two-year Treasuries hit 2.95%, while the 10-year rose to 2.94%. The two-year and five-year portion of the curve also inverted for the first time since February 2020.

The inversions suggest that while investors expect higher near-term rates, they may become increasingly nervous about the Fed’s ability to control inflation without hurting growth, even as policymakers say they are confident in achieving a so-called “soft landing” for the economy. Read more

The Fed has already raised rates by 150 basis points this year, including a whopping 75 basis points increase last month.

The 2 to 10 year segment of the yield curve inverted at the end of March for the first time since 2019 and again in June.

The U.S. curve has inverted before every recession since 1955, followed by a recession between six and 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 a slightly different part of the curve, between the one- 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 March, the last time the 2/10 part of the curve inverted was in 2019. The following year, the United States entered a pandemic-induced recession.

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.

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Reporting by David Randall; Editing by Ira Iosebashvili and Sam Holmes

Our standards: The Thomson Reuters Trust Principles.

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