The yield curve inversion, which had been steadily narrowing, seems to have reached a pause. This may not necessarily be a cause for concern.
Currently, the gap between the two-year government bond yield and the 10-year bond yield stands at approximately 0.47 percentage points. Just a month ago, this gap had shrunk to as little as 0.15, following a consistent trend since the end of July. During that time, investors were absorbing the Federal Reserve’s message on interest rates, hinting at a prolonged period of higher rates. The largest gap between the yields occurred in March, exceeding a whole percentage point.
Historically, a yield inversion—when the two-year yield surpasses the 10-year yield—has often been associated with recession forecasts. This inversion first emerged in July 2022. However, given its enduring presence, doubts have surfaced regarding its predictive power if a recession were to occur in the coming months.
Delving into the mechanics behind bond yields, they primarily serve as indicators of investors’ expectations concerning future inflation and Fed interest rates. Generally, higher inflation or anticipated increases in Fed rates result in higher yields. Consequently, longer-term bonds tend to offer higher yields due to investors’ demands for larger returns when lending money over extended periods.
In summary, although the yield curve inversion has temporarily stalled, it remains pertinent to monitor how it develops in relation to future economic changes. The significance of this inversion in predicting future events is increasingly under scrutiny, and alternative factors should also be taken into account.
Rising Yields and the Possibility of Recession
As inflation surged in 2022, investors adjusted their expectations for short-term rates, causing the two-year rate to surpass the 10-year rate. However, the belief was that these high rates and inflation would not persist indefinitely, resulting in the 10-year rates remaining lower.
During the middle of this year, the Federal Reserve announced a halt in short-term rate increases, but made it clear that interest rates would remain elevated. Subsequently, longer-term rates began to rise, leading to a smaller inversion in bond yields. This development also had a detrimental impact on stocks as increased borrowing costs in the long run typically prove unfavorable for consumers, companies, and overall economic growth.
The latest hike by the Federal Reserve occurred in July and was perceived by the markets as marking the end of the hiking cycle. Presently, in light of consecutive Fed meetings without any adjustment to interest rates and indications that inflation is swiftly cooling down, both two-year and 10-year yields have started to decline.
Does this decline in yields suggest an impending recession? The answer to this question remains uncertain, just as it has been since the middle of last year—no one truly knows.