The Yield Curve is No Longer Inverted. But Some Still See an Impending Recession
The 3-month/10-year curve is at its steepest since May
Recession concerns should be eased now that the yield curve no longer is inverted since it has been a reliable bond-market harbinger of past economic downturns.
And yet, market participants are divided on whether a recent steepening of the curve points to brighter economic prospects, or a more troublesome indication that the U.S. is rushing headlong into a downturn.
The widely-monitored spread between the 3-month bill yieldÂ TMUBMUSD03M,Â -1.35%Â Â and the 10-year note yieldÂ TMUBMUSD10Y,Â -2.28% now trades at a positive 10 basis points differential, after inverting as low as negative 51 basis points in August. Wall Street keeps close tabs on yield curve inversions, or when shorter-term yields trade above their longer-term peers, because their occurrence has preceded the last nine recessions since World War II.
Textbook theory usually would say a positive sloping curve is a sign that expectations for growth and inflationary pressures are weighing on bond prices, thus lifting longer-term yields.
But with a decade of global central bank stimulus producing anything but conventional results, investors see room for debate about how to best read the yield curveâ€™s current position.
â€œThe odds of a recession are coming down with a steeper yield curve. It becomes a more productive environment for risk assets and [corporate bonds],â€ said Thanos Bardas, co-head of global investment-grade at Neuberger Berman, in an interview.
By one metric, the odds of a recession occurring within in one year have fallen to 37.9% in September from 44.1% in August, according to the Federal Reserve Bank of Cleveland, whichÂ tracksÂ the probability of the economy suffering a downturn based on the 3-month/10-year spread.
Some investors say the curveâ€™s positive slope was driven by recent expectations of a breakthrough deal for the U.K. to orderly exit the European Union and by U.S. and China, the worldâ€™s two-largest trading partners, drawing closer to a trade agreement.
They also pointed to the Fedâ€™s announcement last week to buy $60 billion dollars of Treasury bills every months, at least through June, as helping push down yields for short-dated Treasurys, which has contributed to the inversion in the 3-month/10-year spread.
But a more pessimistic read would underscore how the steepening of the yield curve, after an inversion, has preceded the last three recessions.
â€œAn un-inverted yield curve is no cause for celebration, instead it is the quiet before the storm,â€ warned Philip Marey, senior U.S. strategist for Rabobank, in a recent client note.
Rather than the bond-market signaling investors are in the all-clear, Marey expects that a recession could hit in the second half of 2020.
But Wall Street often finds ways to cash-in on recessions. And betting on a steeper yield curve, following an inversion, has been a time-tested bond-market strategy.
Traders often look to take short position on long-dated bonds, while simultaneously buying short-dated debt, under the theory that any central bank intervention designed to combat deteriorating economic conditions, will also push down short-term yields.
Earlier this month, Citibank strategistsÂ suggested that betting on a steeper yield curveÂ on the 2-year/10-year spread was one of the best ways to profit from the rising chance of a recession.
Yet, this time around, the Fed has been hesitant to indicate a need for further rate cuts beyond its â€œmid-cycleâ€ adjustments. That was the phrase Fed Chairman Jerome Powell used to characterized a pair of quarter-point cuts in the summer. And more hawkish members of the Federal Open Market Committee, the central bankâ€™s rate-setting body, such as Boston Fed President Eric Rosengren, have said additional easing could amplify financial instability.
â€œThe speed with which the Fed is adjusting policy is very slow,â€ said Gregory Faranello, head of U.S. rates at AmeriVet Securities, in an interview. â€œItâ€™s been a very frustrating trade, you need the stars to align, to make the curve meaningfully steepen here.â€
He said the curve was likely to stay relatively flat in the coming months until signs of a pick-up in global growth emerged. A slowing world economy has pushed down bond yields across the world, drawing income-hungry investors to the U.S., one of the few pockets of financial markets where yields for developed-market government debt is still positive.
By: Sunny OhÂ