For just a moment on Tuesday, investors and analysts held their breaths as the yield curve between 2-year and 10-year Treasurys inverted by 0.03 basis points. This marks the most recent instance of a yield curve inversion since 2019.
So, what does a Treasury yield inversion mean for the economy?
Well, the spread between Treasury yields has been something of a recession barometer for the better part of 50 years. As the curve flattens, or the spread between 10-year and 2-year Treasurys shrinks, Wall Street starts to watch out for a recession. In fact, the yield curve has inverted within 18 months prior to every U.S. recession since World War II.
Long-term Treasurys should just about always yield a greater return than short-term notes. Reasonably so, as a Treasury is basically a loan to the government. The longer the length of a loan, the greater the expected return. However, in times of widespread uncertainty, or when investors hold a bleak long-term view on the economy, it is possible for short-term bonds to yield a greater return than their 10-year and 20-year counterparts. This is what is considered a yield curve inversion.
Given current inflation concerns, impending interest rate hikes, and supply-chain hiccups stemming from the Russian invasion of Ukraine, uncertainty is, at the very least, excusable.
The spread between 10-year and 2-year Treasurys has just about always been the gold standard for measuring the likelihood of a recession. With that said, the 5-year and 30-year curve also inverted this week, for the first time since 2006.
With Tuesday’s inversion, the theory war has already begun. Analysts are voicing their thoughts on what it means, and surprise: Not everyone is in agreement.
Does the Yield Curve Inversion Mean a Recession Is on the Way?
While it’s true that the yield curves have inverted prior to every American recession since the 1950s, the opposite is not. Just because the yield curves inverted doesn’t mean the economy is destined to recede. In fact, many analysts argue that the last time the curves inverted had basically nothing to do with the economy. Instead, it was the Covid-19 pandemic that shut down the economy. Prior to the pandemic the economy was strong, leaving the 2019 inversion with little meaning or precedent.
On March 25, the Federal Reserve even put out a paper arguing against the predictive power of the 2- and 10-year spread. Fed Chair Jerome Powell stated last week he is more interested in the spread between much shorter-term notes, which appears less troublesome. However, some experts think the numbers speak for themselves.
“Historically, a recession has not happened without an inversion,” said macroeconomic strategist Ben Emons. “So likely, it will be a predictor of a future recession. Timing, however, is unknown. It could take up to two years.”
Some Express Doubt in Treasury Yield Spread
Not everyone feels the 2-10 spread is as telling, however.
Some have argued the 10-year notes have become grossly undervalued due to the Fed’s bond-buying program over the past few years. As such, the fact that their yield is merging with shorter-term notes is more reflective of supply and demand rather than a doomsday economic indicator. This isn’t a fruitless argument.
The Fed’s quantitative easing (QE) program was basically an accelerated effort to inject money into the economy by purchasing large quantities of various assets. As such, some strategists estimate the 10-year yield would be closer to 3.6% without the QE stimulus efforts. This is a far cry from its current 2.36% yield.
While it’s unclear whether Tuesday’s action will prove an indicator of a future recession, expect analysts to continue watching the bond markets closely amidst tightening monetary policy.
On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
