Posted by lplresearch
Tuesday, April 5, 2022
The shape of U.S Treasury yield curve is often looked at as a barometer for U.S. economic growth. More specifically, it reflects how the Federal Reserve (Fed) intends to stimulate or slow economic growth by cutting or raising its policy rate. Each tenor on the curve is roughly the expected policy rate plus or minus a term premium (the term premium represents the expected compensation for lending for longer periods of time). In “normal” times, the yield curve is upward sloping, meaning longer maturity Treasury yields are higher than shorter maturity Treasury yields. However, when the economy is growing too quickly, inflationary pressures are apparent, and the Fed wants to slow growth, shorter maturity securities could eventually out-yield longer maturity securities, inverting the yield curve.
“Yield curve inversion is likely going to be the phrase of the year in 2022,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “However, we don’t think recession is in the cards for this year. If the Fed follows through with the expected rate hikes however—a big if—we’re likely going to see the 3 month/ 10 year close to inversion by the end of the year, which would likely mean recession could be a 2023/2024 event.”
When we look at the yield curve currently, we see two different signals. As seen on the LPL Chart of the Day, the 2-year yield is currently out-yielding the 10-year Treasury yield and is thus inverted. However, when we look at shorter maturities, such as the difference between the 3-month Treasury yield and the 10-year Treasury yield, the curve is still very steep, which makes sense since the Fed has only raised interest rates by 25 basis points (0.25%) this year. The difference in the 2-year Treasury yield and the 10-year Treasury yield measures market expectations of what the Fed may do—not what it has already done. Using shorter parts of the yield curve, which is what the academic research supports, measures what the Fed has already done and may be a better indicator of near-term recession risks. Fed rate hikes are used to slow economic growth so it’s the reality of these hikes that leads the economy to contract—not the threat of rate hikes.
The past six times the 2Y/10Y part of the yield curve inverted, a recession followed, on average, 18 months later. However, the length of time between the quickest time to recession (6 months) and the longest time until recession (nearly 36 months!) complicates the signal and in the Fed’s words, the relationship is probably spurious. Additionally, the signal may not be as robust as it once was as central banks around the world have implemented aggressive quantitative easing programs that have likely impacted market signals. In the U.S., for example, the Fed owns more than 25% of Treasury securities outstanding and continues to reinvest coupon and principal payments into the Treasury market.
That said, we don’t think investors should ignore the 2Y/10Y signal altogether. We acknowledge that given the nuances surrounding current economic dynamics and with the Fed likely to respond more aggressively than previous rate hiking campaigns to arrest stubbornly high consumer price increases, recessionary risks have likely been pulled forward into 2023/2024. That said, we still expect the economy to grow above trend this year given underlying consumer strength.
IMPORTANT DISCLOSURES
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.
All index and market data from FactSet and MarketWatch.
This Research material was prepared by LPL Financial, LLC.
Securities and advisory services offered through LPL Financial (LPL), a registered investment advisor and broker-dealer (member FINRA/SIPC).
Insurance products are offered through LPL or its licensed affiliates. To the extent you are receiving investment advice from a separately registered independent investment advisor that is not an LPL affiliate, please note LPL makes no representation with respect to such entity.
- Not Insured by FDIC/NCUA or Any Other Government Agency
- Not Bank/Credit Union Guaranteed
- Not Bank/Credit Union Deposits or Obligations
- May Lose Value