- November 30, 2018
- Posted by: Trading
- Category: News
The dreaded inversion of the yield curve is nigh, but in an oft-ignored section of its slope.
“Maybe this is what the Fed fears most,” said David Rosenberg, chief economist for Gluskin Sheff, in a note.
The feared bond market indicator, measured by the gap between short-dated and long-dated yields, has turned inside out before the onset of the last nine recessions. If triggered, an inverted curve would set off fears that the U.S.’s second-longest expansion since World War II may buckle under the pressure of the Federal Reserve’s steady but relentless rate hikes.
That’s why Rosenberg and other investors have highlighted the fast shrinking gap between the 2-year note
and the 5-year note
as a sign of the economy’s deteriorating prospects, even though this pairing isn’t a widely shared gauge of the curve’s slope. The spread between the two short-dated maturities last traded at 3 basis points on Friday, from 31 basis points at the start of 2018, according to Tradeweb.
Senior Fed officials have acknowledged the yield curve inversion as a recession indicator. Atlanta Fed President Raphael Bostic and St. Louis Fed President James Bullard have warned against deliberately triggering the bond market indicator. But others, including Fed Chairman Jerome Powell, have dismissed its role in the central bank’s decisions.
Admittedly, the spread between the 2-year note and the 5-year note is not a common way to assess the curve’s slope, with both seen as short-dated maturities where inflation expectations play less of a role than the outlook for Fed policy.
After all, the predictive power of the curve inversion comes from its pairing of a short-dated bond with a long-dated bond as their interplay shows how the Fed interacts with Wall Street’s outlook for the economy.
In times of solid growth, the curve slopes upwards as investors demand higher yields for holding longer-maturity bonds as compensation for the risk of higher inflation.
When the central bank does start to ratchet up interest rates to prevent the economy from overheating, short-dated yields tend to surge. At the same time, the weight of higher borrowing costs slams consumers and businesses, softening growth and inflation expectations and sending long-dated yields lower. The overall effect is a flat, and sometimes inverted, yield curve.
All the same, the gap between the 2s and 5s tracks other more popular measures of the curve’s steepness, and could signal that inversions at other parts of the yield curve are imminent, said Ian Lyngen, head of U.S. rates strategy, at BMO Capital Markets.
The last time this spread had inverted was back in June 2007, several days after the ubiquitous gap between the 2-year note and the 10-year note also inverted. Later in 2008, the financial crisis swept through the economy, forcing the Fed to slash interest rates to zero.
Even as the yield curve flattens, some investors like Joe Ramos, head of U.S. fixed income for Lazard Asset Management, are skeptical of the curve’s powers as a recession indicator this time around. He argues that low interest-rate policies by the world’s major central banks have artificially capped long-dated yields, with the flattening curve not necessarily pointing at a slowdown in the economy.
But many more remain wary of defying the curve’s prognostications, seeing an inversion at least as a harbinger of volatility for financial markets in the months ahead.
Providing critical information for the U.S. trading day. Subscribe to MarketWatch’s free Need to Know newsletter. Sign up here.