Risk of recession, because it could really come: the signal from the markets

The alarm for more than 200 consecutive trading days: Treasury yield curve constantly inverted since July 5, 2022

The markets’ favorite indicator of recession has sounded the alarm for more than 200 consecutive trading days, or the longest period since 1980: the clear message is that the US will not be spared from a brake on growth.

Specifically, the Treasury yield curve, represented as the difference between the yield on the 2-year Treasury note and the yield on the 10-year note, has been consistently inverted since July 5, 2022, according to Dow Jones Market Data. This is the longest series in which short-term yields have eclipsed long-term yields since May 1980.

The signal is not heartening and tells of an impending recession. In fact, longer-dated bonds typically offer higher yields because investors want to be compensated for the additional risk they take on by purchasing longer-dated debt.

However, when fears of a recession grow or the Fed raises interest rates aggressively, this relationship can be reversed. Short-dated bond yields are higher because there are fears that an imminent economic slowdown will jeopardize the government’s ability to repay investors. Which, in turn, want a higher outlay in terms of interest rates (coupons) to keep the debt purchased.

An inverted curve has preceded every US recession since the early 1960s, said Campbell Harvey, a finance professor at Duke University. The expert also noted that the particularly deep reversal caused problems for the banking sector, helping to instigate the collapse of Silicon Valley Bank and other institutions.

Right now, it’s hard to say when the ratio of short-term to long-term bond yields might return to normal. According to Priya Misra, a strategist at TD Securities, to find optimism investors should believe that inflation is defeated or that the US economy will succeed.