JThis morning, investors will have woken up to scary headlines on the yield curve. Overnight, an oft-watched part of that curve reversed; the yield on the 2-year Treasury rose above that of the 10-year. This, according to the stories, is generally seen by traders and analysts as the harbinger of a recession. The questions for investors are: Why do traders see things this way, and are we on the verge of a recession?
The “why” is the easier of the two to answer. The reversal means traders are betting on lower interest rates in ten years than they will be in two. Since interest rates are raised by central banks in a strong economy and lowered when weakness appears, this implies that these traders expect a period of strength to be followed by a period of weakness.
It is much more difficult to say whether this will happen or not.
A recession follows an inversion about two-thirds of the time, usually within one to two years. Of course, that also means it isn’t a third of the time. While this is something of an indicator, the relationship between an inverted yield curve and recession is far from set in stone. Simply put, as anyone who has ever traded knows very well: traders are sometimes wrong. Also, sometimes they succeed, but perhaps more by luck than judgment.
For example, the last such reversal occurred in 2019 and, of course, there was a recession, generally defined as two consecutive quarters of declining economic activity, the following year. This, however, was the result of an almost complete shutdown of the global economy in response to Covid. Bond traders are smart people. I know this because every one of them I’ve met has told me this, but do you really think they saw the global pandemic happen a year before it happened? Obviously not, so the relationship between the curve inversion and the recession in this case was more of a coincidence than anything.
Still, a strike rate of 66% is good enough for any market signal, so how worried should investors be? At this point, not very.
First, as I said, there is a significant lag between the inversion and the recession when it occurs, which is why there was no reaction in the stock market this morning. All major indices are pointing to a higher open as of this writing, so it’s clear stock traders are taking it in stride. Second, there is another very plausible reason for this reversal which, while not exactly inspiring confidence, does not mean that a recession is imminent.
The Fed is embarking on a major policy shift, declaring its intention to raise rates quickly after a long period of holding at historic lows. That in itself puts upward pressure on the short end of the curve and is a big part of the reason for this move, but the reaction to it is also important in another way. This may signal a lack of market confidence in this Fed. There is a widespread feeling that they got it wrong, insisting that inflation had been “transient” for too long, forcing drastic action once the mistake was acknowledged. What traders seem to be saying now is that the pendulum has swung too far the other way; this policy will go too far too fast in the other direction and will create problems in the future.
This, however, assumes that Powell et al will not have learned from their mistake (if it was indeed a mistake), or that they were right all along and inflation will dissipate quickly, leading a reversal of policy reversal. Given the exceptional supply chain issues we’ve had post Covid, that’s not an unreasonable assumption and if that’s what’s actually happening then the return to rates below the yield curve signal would be due to the fact that inflation was brought under control quickly and effectively. Far from being a nightmare scenario, it would be positive for the markets and the economy in a few years.
For investors, the key here is to adopt a wait-and-see approach. An inverted yield curve tells us that the market expects yields to fall in the future, but not why. In these exceptional circumstances, the why might be because the Fed, by reversing its policy when it did, faced immediate danger and warded it off. If so, the reversal is not a warning sign at all and could even be considered a positive signal. If the negative 2s-10s spread widens and holds then this might be a cause for concern but, for now, it is not so the best strategy is to ignore the headlines and to keep looking for quality names that are trading. at a discount to recent values.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.