Updated: Mar 29, 2019
Authors: Jerusan Jegatheeswaran Co-VP Research, Dragos Cada Co-VP Research, Alice Li Research Analyst, Helen Feng Research Analyst, Amy Li Research Analyst
First Treasury Yield Inversion Since 2007: Recession Watch
Although Federal Reserve Chairman Jerome Powell asserted this week that the U.S. economy remains strong, the news faces a stern test from the bond market. A significant part of the U.S. treasury yield curve inverted on Friday, March. 22nd, a looming sign of a potential recession. For the first time since before the Great Recession, the 3-month treasury yield is sitting at 2 basis points higher than that of the 10-year treasury yield, at a rate of 2.46 percent. This breaks the longest streak ever of the spread between the 3-month and 10-year Treasury notes being above 10 basis points, showing investors’ diminishing confidence in the economy's prospects.
Significance of the Treasury Yield Inversion
The spread between the 3-month and 10-year treasury yield is a closely watched figure and serves as a prominent warning sign of recession. According to Federal Reserve Bank of Cleveland, an inversion of this yield has preceded each of the last seven recessions. Once this inversion takes place, a recession may hit in about one year.
Historical Spread Between 3-Month & 10-Year Treasury Yields
Source: Federal Reserve Bank of St. Louis
Shaded areas indicate recession as shown in the graph above. The last time this inversion occurred was in late 2006 and early 2007, before the fall of the major recession in December 2007.
Reasons for Inversion
Usually, short-term bond yields are lower than that of long-term debt to compensate investors for the increased risk exposure from a longer holding period. When short-term yields move ahead of longer-duration ones, it is a worrying sign that investors believe economic growth will slow down in the future. As one of the world’s safest investments, nervous investors purchase more treasuries and less risky assets such as stocks. The increased demand for bonds will drive up prices and send yields falling.
U.S. central bank policy makers lowered both growth projections and interest rate outlook on Wednesday. On the other hand, shorter term rates are influenced more by the Federal Reserve, which has raised its benchmark short term rate seven times in the last two years. The rate hikes forced up the three-month yield from 1.71 percent a year ago to 2.46 percent on Friday.
Although economic growth is slowing around the world, the U.S. job market remains relatively strong. This inversion of the treasury yield is a signal we should take seriously. However, the more important factor may be how businesses and consumers react to the news. If they decide to cut back on spending or hiring, then a recession could in turn be triggered. Furthermore, another closely watched figure by Wall Street is the difference between 2-year and 10-year treasuries, which has not yet inverted. Thus, it is still too early to say.