Yield Curve Inversions Signaling Caution Rather Than Recession
Late in any economic cycle, investors will turn their attention to the U.S. Treasury yield curve, a bond-market gauge viewed as a harbinger of the economic outlook. The curve itself is a graph of the relationship between Treasury yields and time to maturity. It usually slopes upward, from left to right, indicating investors demand more compensation to own longer-term bonds – to offset the risk that economic growth or inflation may accelerate over time.
The curve has a track record for foreshadowing recessions when it inverts, meaning when shorter-dated yields move above longer-dated ones. Lately, inversions have appeared between various points along the curve, spurring investors to ask whether these are omens of a recession.
That’s a complicated question in the current economic cycle, which saw a sudden downturn in 2020 and a rapid rebound fueled by unprecedented central-bank stimulus. The Federal Reserve began withdrawing that stimulus in March with the first of several expected interest-rate hikes to tame inflation. The Fed is also expected to start unwinding its bond-buying program this year.
A yield curve inversion should never be dismissed just because the backdrop has changed. That said, the curve’s signal may be less clear than in the past.
Curve flattening often occurs later in a cycle when central banks raise short-term policy rates to restrain growth and inflation. Short-term yields can rise to reflect these hikes, while long-term rates may fall as expectations for inflation and growth moderate. This time, the flattening occurred quickly and well ahead of the first Fed hike. Inflation could continue to overshoot expectations, which could spur the Fed to further accelerate its hiking pace.
Longer-dated gauges like the two-year/10-year and five-year/30-year Treasury curves can be more valuable than the widely followed three-month/10-year curve, in our view. The reason is that the Fed has already laid out its rate-hike projections in its “dot plot” forecast, and looking at market rates over a short-term horizon may be less informative than focusing on what the Fed is saying it will do.
The most important curve to follow is likely the forward curve, a market-based measure that incorporates existing – or spot – rates as well as implied rates further down the road. For example, to compare a bond maturing in one year with one coming due in two years, the forward curve accounts for the expected one-year interest rate a year from now.
By factoring in the compounded rate of return necessary to differentiate between any points on the yield curve, the forward curve uses all known information and can be more relevant than a spot curve, which doesn’t incorporate expected changes in short-term rates. The forward curve is now sharply inverted.
Does this mean a recession is imminent? No, but it is a risk to monitor. The global economy and policymakers are confronted with a supply shock that is negative for growth and will tend to push up inflation further. Most central banks seem determined to opt for fighting inflation over supporting growth. This raises the risk of a hard landing down the road.
PIMCO is calling for above-trend growth and a gradual easing of inflation pressures from higher peaks in developed market economies. However, the risks of higher inflation and lower growth have increased, along with the risk of recession in 2023 (for more details, read PIMCO’s latest Cyclical Outlook, “Anti-Goldilocks”).
The current shape of the yield curve underscores why investors need to be flexible. Simple bond math – which factors in price, yield, and reinvestment rate – suggests that investors aren’t picking up enough extra yield when buying long-dated Treasuries today. At recent levels, not only does a two-year Treasury offer a similar yield to a 30-year bond, but it provides the opportunity to make a reinvestment decision in two years rather than waiting another 28.
With that in mind, PIMCO is slightly underweight duration, or interest-rate risk, with most of that underweight at the long end of the curve. If inflation remains persistent, it could hurt 30-year bonds the most. Also, as the Fed goes from buying bonds (quantitative easing) to selling them (quantitative tightening), that may unwind some factors that have suppressed the term premium, or the difference between long- and short-dated yields. We see potential opportunity in shorter maturities of 2-5 years.
We now appear firmly in the late stage of the economic cycle, with underlying growth momentum still strong but increasingly vulnerable to downside risk. We will tend to emphasize keeping powder dry in an effort to take advantage of dislocations in markets as they arise.
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Marc P. Seidner is CIO Non-traditional Strategies.
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