Posted by Lawrence Gillum, CFA, Fixed Income Strategist
Tuesday, January 10, 2023
Last November we noted that the shape of the U.S. Treasury yield curve is often looked at as a barometer for U.S. economic growth. Moreover, we noted that the spread between the 3-month T-Bill yield and the 10-year Treasury yield (3M/10Y) has been a fairly reliable recession signal, having correctly predicted essentially every U.S. recession since 1950, with only one “false” signal, which preceded the credit crunch and slowdown in production in 1967. Recently, however, the finance professor that pioneered the use of the yield curve as a recession signal has cautioned that this time may in fact be different—something we have noted in prior missives as well.
Complicating the signal this time around is twofold: the Federal Reserve (Fed) is in the midst of one of its most aggressive rate hiking campaigns in history and interest rates are still at fairly low levels (thus the starting spread between the two tenors was fairly tight). The front-end of the Treasury yield curve has moved higher in concert with the Fed’s hiking campaign that took the fed funds rate to 4.5% (upper bound). Thus, the 3-month T-bill is roughly anchored at those elevated levels. However, the 10-year Treasury yield, which is influenced more by economic growth and inflation expectations, has fallen roughly 0.75% from its peak in October at 4.24%. Most of the fall in yields, though, has been due to declining inflation expectations along with falling inflation uncertainty and not concerns about slowing economic growth. So, with the 3M anchored, the fall in the 10-year has pushed the 3M/10Y spread to its deepest levels since the 1980s and thus indicating a recession is almost a certainty. In fact, the probability of recession, according to the 3M/10Y signal, is greater than before the global financial crisis, the dot com bubble and the COVID slowdown. We think that may be overstated.
And while we aren’t ignoring the signal completely we think the level of yield curve inversion is perhaps steeper/deeper than actual economic conditions may warrant. We think the odds are roughly a coin toss that the U.S. economy falls into a recession in 2023 but it is no sure thing. The consumer is still spending and with businesses still hiring at an elevated clip, there is a chance that we can skirt by with an economic slowdown and not an outright contraction—although if the economy does contract, we think it will be a shallow contraction due to the aforementioned reasons. It’s also important to point out that the last time the 3M/10Y yield curve was inverted, the economy fell into a recession because of a global pandemic—something we would argue was not priced into the inversion yet it still gets “credit” for the signal. Economic models help simplify a complex world but it’s important to remember that the signal isn’t always accurate and sometimes things, are in fact, different.
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