Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Chart of the Week : The inverted yield curve
Christopher Dembik
Head of Macroeconomic Research
Summary: In today’s ‘Macro Chartmania’, we focus on the inverted yield curve. It is known as an ominous indicator of the upcoming U.S. recession. But it is sending a false signal now, in our view.
Click here to download this week's full edition of Macro Chartmania composed of more than 100 charts to track the latest macroeconomic and market developments.
An inverted yield curve occurs when U.S. yields on shorter-dated bonds jump above the ten-year. This is usually the signal that investors expect a deterioration in near-term economic conditions and aggressive intervention from the U.S. Federal Reserve (Fed). Therefore, they want more compensation for loaning money out two years than they do for ten years, for instance. There are at least two yield curves usually watched: the two-year/ten-year spread (the most common indicator used) and the one-year/ten-year (most often mentioned by Fed research papers). Why this matters now: short-term government bonds yields (between three months and five years) have risen more than long ones this year, thus fattening the curve. The curve is not inverted yet. But it follows a steep downward trend. The two-year/ten-years stands now at +45 basis points. It was at +89 basis points in early January. The flattening of the curve partially reflects market expectations that the Fed will hike interest rates several times in the coming months to contain inflation. This is seen by some investors as a bearish signal that the risk of recession is increasing in the U.S. too.
The yield curve inversion has a decent track record to predict a recession. It has successfully predicted all but one of recent U.S. recessions since the 1970s (the only two exceptions are the recession of 1990 and the inversion of 2019 which did not predict anything). But this time is different. The curve is probably sending a false signal, in our view. Massive quantitative easing has depressed the term premium and the long end of the curve is heavily distorted. There are also distortions caused by a preference for safe-haven assets in the current period market by higher geopolitical risk. This preference especially causes higher demand for ten-year Treasury bonds (negative risk premium). The influence of these two factors cannot be ignored. We don’t say that investors should dismiss signals sent by the curve. But they need to be carefully interpreted. There is nothing magical about going to zero. It might happen in the coming months or quarters, but this won’t necessarily mean that recession is about to come. Only a big inversion of the yield curve is likely to be a troubling signal. This is not yet the case.
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