Will the yield curve lead to recession? It really is different this time
Illustration: Aïda Amer/Axios
Yields on 10-year U.S. Treasury notes fell below 3-month Treasury bills on Friday for the first time since 2007, triggering a major recession indicator.
Yes, but: Market analysts have tripped over one another telling us not to worry. This time is different, they insist. And while strategists with high S&P 500 targets are notorious for balking at clear and longstanding recession indicators, they do have a point. Things are different now.
What's happening: Since Friday's yield curve inversion, the market further positioned for a recession or at least something much worse than the slowdown to 2.1% growth the Fed is predicting.
- "A lot of investors are spooked and really putting on the recession trade, so to speak," Gennadiy Goldberg, interest rates strategist at TD Securities, tells Axios. "The extent to which we're pricing in rate cuts suggests we're pricing something more sinister than just rate cuts."
The big picture: While investors have implored anxious Americans to look to the strong U.S. labor market and solid 2018 GDP numbers, what's really changed is the impact of central banks.
- "In the past when yield curves inverted it was entirely the result of the perceptions of investors in the financial markets," Bernard Baumohl, chief global economist at The Economic Outlook Group, tells Axios. "Now we have seen central banks become heavily involved in the bond market."
Background: After the financial crisis, the Fed's quantitative easing program saw the central bank tack around $4.5 trillion worth of bonds onto its balance sheet — much of it longer-dated U.S. Treasuries — in an effort to depress yields and support financial institutions.
Fed Chair Jay Powell announced earlier this month that the Fed would stop reducing those holdings once the balance sheet gets to around $3.5 trillion.
- "There’s still that stock effect of all those assets they purchased that is holding down longer-term yields as a result," Steve Johnson, senior portfolio manager at Silicon Valley Bank, tells Axios.
And it's not just the Fed. The ECB and BOJ both have negative interest rates for some deposits. German and Japanese 10-year government bonds now have negative yields. That's driving a flurry of investors to U.S. Treasuries, which pay significantly more.
Don't forget: There's also the $1 trillion annual U.S. deficit and unprecedented $22 trillion national debt. The deficit is being funded by issuing more short-dated Treasury bills than longer-dated notes, helping invert the curve, Baumohl says.
The bottom line: The yield curve has inverted before the last 7 U.S. recessions, making it impossible to ignore. But the Fed's quantitative easing programs and subsequent stimulus efforts by governments and central banks around the world have distorted markets. It's hard to rely on historical correlations, positive or negative, because we've never seen this before.