The inversion of the yield curve, a popular recession predictor for Wall Street, is showing signs of normalization. However, the way in which the curve un-inverts holds significance for investors as well.
Understanding the Inversion
Since July 2022, the yield curve has been downward sloping, with shorter-term bills and notes having higher yields compared to longer-term securities. This inversion of the yield curve defies the typical pattern, where longer-term investments are associated with higher yields due to inflation and interest-rate uncertainty over time.
Over the past 15 months, investors have been factoring in higher interest rates and economic risks in the near term. Consequently, the yields on the short-term end of the curve have surpassed those on the long-end. Historically, an inverted yield curve has reliably preceded every U.S. recession since the 1950s. Inversions of the 2-year and 10-year yields, considered a key pair, have preceded recessions within a span of seven months to two years according to Dow Jones Market Data.
The Current Situation
As of now, the spread between the 2-year and 10-year yields has decreased to 0.29 points from nearly 1.1 percentage points seen in early July. The 2-year yield stands at 5.07% while the 10-year yield sits at 4.78%. On the other hand, the yield for the 30-year Treasury bond is 4.94%, surpassing the yields for the 3-year, 5-year, and 10-year bonds. The highest yield on the curve is currently held by the six-month Treasury bill at 5.58%.
The Un-Inverting Process
The method by which the yield curve un-inverts holds significance. There are two possible scenarios—either the 2-year yield falls more rapidly than the 10-year yield, or the 10-year yield rises faster than the 2-year yield. Both instances result in a steeper yield curve. The former is known as a bull steepener, whereas the latter, a bear steepener, carries a more ominous connotation.
In a bull steepener scenario, markets typically anticipate imminent interest-rate cuts by the Federal Reserve, leading to a sharp decline in near-term yields. This often occurs just before a recession.
The Bear Steepener: Impact on the Economy and Financial Markets
In today's economic landscape, a bear steepener is occurring due to the resilience of the economy and labor market. This phenomenon is causing longer-term yields to rise as investors anticipate a prolonged period of higher interest rates set by the Federal Reserve. Factors such as the Fed's quantitative tightening and increased Treasury issuance have also contributed to this trend. The implications of a bear steepener include tighter financial conditions, higher borrowing costs for individuals and businesses, and intensified competition for alternative assets like stocks. As a result, there is an increased likelihood of a weaker labor market and a potential recession.
According to Tan Kai Xian, a U.S. analyst at Gavekal Research, one of the significant consequences of this bear steepening is its impact on the net interest expenses of U.S. non-financial firms. At a time when the economic cycle is at a critical juncture, higher net interest expenses can weigh on corporate profits, prompting cost-cutting measures such as employee layoffs.
The dynamics of a bear steepener are rooted in the way individuals and businesses tend to borrow over the long term while keeping their cash in short-term instruments. When a bear steepening occurs, interest expenses on borrowings increase at a faster rate compared to returns on cash equivalents, leading to a rise in net interest expenses. This places a drag on the overall economy.
Bear steepenings are relatively uncommon compared to bull steepenings—a phenomenon characterized by the opposite yield curve movement.
Jonas Goltermann, deputy chief markets economist at Capital Economics, explains that bear steepenings typically occur at the onset of an economic cycle when growth is picking up. However, when the yield curve bear steepens while already inverted (as it is now), it usually signifies the beginning of a recession. Historically, this has been followed by significant declines in long-term government bond yields and equity indices.
Therefore, it is plausible that the current bear steepener could eventually transition into a bull steepener if the fear of a recession prompts Wall Street to seek refuge in long-term Treasuries and the Federal Reserve decides to reduce short-term rates. However, any such shift would likely come with economic and stock market challenges.
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